ETN Risk Rears Its Ugly Head

On Tuesday, Morgan Stanley analysts declared that  HSBC Holdings Plc (HBC) may have a weaker capital position than most investors believe, and the equity market shuddered. This concerns us not only due to the hit that the financial sector subsequently took, but also because we have exposure to HSBC USA through the Morningstar ETFInvestor's Hands-Free portfolio holding  ELEMENTS S&P CTI ETN . This fund, just like every other ETN, is a debt instrument. HSBC USA, a subsidiary of HSBC Holdings, guarantees the issuance and redemption of shares of the LSC for their published intraday value (the "fair value" of the index, minus 0.75% in annual expenses) on demand, and has promised to continue supporting the ETN liability through June 16, 2023. However, should HSBC USA declare bankruptcy, this ETN does not have an underlying portfolio on which LSC shareholders can lay claim. Instead, they would have to get in line with all of the bank's other creditors to try and snatch back whatever share of the post-restructuring assets they are owed.

However, this news does not worry us too much. We have warned investors multiple times about the credit risk inherent in ETNs, but HSBC remains one of the banks with the lowest chances of default out there (though that may seem very faint praise right now). The bank warned about subprime mortgage losses back in December 2006 and limited its exposure to the most overheated parts of the U.S. and U.K. credit markets. By the end of September 2008, HSBC's tier 1 capital ratio of 8.9% exceeded that of nearly all multinational rivals, and even today it remains the most valuable bank in the world by market capitalization. Even though the HSBC USA subsidiary is in a slightly worse position than the parent company, it would be unprecedented for HSBC Holdings to cut off equity support and allow its enormous U.S. group to go bankrupt.

The concerns of the Morgan Stanley analysts and others are in regards to the value of HSBC's common equity, not its debt or even preferred shares. While HSBC retained a solid balance sheet through the crisis at the end of last year, rivals such as Santander ,  Citigroup (C),  J.P. Morgan Chase (JPM), and  Royal Bank of Scotland (RBS) were all forced to either raise new equity capital or accept government rescue funds. HSBC is still likely to hold an equity cushion that would have been enviable in 2006 (we will not know for sure until it announces its full-year results for 2008), but it no longer looks as safe when the other major banks have been forced to raise nearly $800 billion since 2007. The bank's main risk exposure right now lies in its consumer loans in the U.K. and U.S. As default rates rise and HSBC tries to reduce its leverage to match the newly capitalized banks, analysts expect the company to cut dividends so that continued earnings add to the company's cash cushion instead of going out the door to shareholders. In a bearish scenario, it may even need to raise up to $30 billion by issuing new common stock. Either of these scenarios would only help the position of HSBC's debtholders, including shareholders of the ELEMENTS S&P CTI ETN.

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