(NYTimes) $GJN, “The security in question was extraordinarily complex in its name and its details, but simple in its selling points. It was marketed in $25 units, a popular price point for debtlike securities sold to individual investors, and it promised monthly interest payments for as long as 30 years, at which point the investor would get the $25 back. Those interest payments would fluctuate with interest rates on Treasury bills, but could not go below 3 percent a year or above 8 percent.”

“Wells Fargo, the bank behind the security, now says that anyone who had read the prospectus should have understood that disaster was looming in June, when news related to the security was disclosed. But that disclosure — I’ll get to the details in a minute — had the opposite effect on the market. In New York Stock Exchange trading, the price leapt higher, on heavy volume, and stayed there for weeks.”

“The price per share was $24.88 on July 12, when trading was halted as investors learned they would get just $14.69 a share. Trading never resumed. .. The difference between market expectations and realities boiled down to one fact: Wells Fargo concluded it was entitled to a payment of $10.69 a share to compensate it for the profits it would have made over the next 23 years had the security not been redeemed.”

“That was disclosed, on Page S-12 of the prospectus supplement, and investors were warned that ‘this loss could be quite substantial.’ Wells Fargo thinks that was perfectly adequate disclosure, even though no examples were given to indicate the possible magnitude of the termination payment.”

” ‘It was a very conservative security,’ said one investor, a computer science professor who lost money on an investment he had thought was ‘a very nice, Grandma type” of security.’ ”

” .. The bank had hedged its own exposure to that swap, she said, and it lost money on that hedge. “Substantially all of that payment was used in connection with unwinding hedges,” she said of the $10.97 a share Wells Fargo received. She  said the ‘securities were structured to meet investor demand at the time’ they were issued, ‘and the circumstances governing termination were fully disclosed to investors.’  She added that Wells Fargo might have had to pay money to investors on the swap if it had been terminated when interest rates were high, meaning the investors could have gotten a windfall instead of large losses. That strikes me as protesting too much. Under those circumstances, JPMorgan would not have wanted to redeem its security, and would not have done so. ”

So, if rates went UP, meaning that there was almost no chance of JP Morgan calling in the security early, investors might have MADE money?!  Sounds like their “hedge” was put on diametrically opposed to any common sense whatsoever.

“Ed Hall, a lawyer and blogger who has written on Strats — and who brought the security to my attention — says he thinks it is obvious that the investors had no understanding of the risks. “Wells needed to place a clear warning at the start of the prospectus, rather than buried deep in the prospectus,” he said.”

Full Story: Buried in Details, a Warning to Investors (NYTimes)

(Stocks, Bonds & Politics) “If an adequate warning had been placed in bold and large type at the beginning of the prospectus, WFC/Wachovia would not have been able to sell those certificates to the public at $25. The deal would not have gotten off the ground. There may be a statute of limitations issue, but I seriously doubt that the average individual investor could have reasonably foreseen the events that led up to their loss of capital until WFC took their money in mid-July 2012. On that issue, it is relevant that GJN was trading near $25 up to the time of its delisting.” — Wells Fargo-GJN-Securities Act of 1933

(GlobeInvestor) “ETNs expose investors to the risk of losing all or most of their principal. That’s because ETNs are set up as unsecured, long-term debt obligations of the issuer, Ms. Pelant explains. ETF investors don’t face the same default risk because ETFs own a pro rata stake in a basket of stocks, bonds, or derivatives held by a custodian in trust and legally separate from the issuer, she says.”

“When Morgan Stanley’s viability came under question in September , its family of Market Vectors ETNs sold off dramatically. ‘The Market Vectors Remnimbi/USD ETN (CNY) plunged more than 25 per cent versus a 1-per-cent drop in a comparable ETF,’ observes Greg Newton, a veteran financial journalist who writes the NakedShorts blog.”

However, if the ETFs don’t actually hold the securities that make up the fund, and instead use synthetics or swaps rather than physicals, investors may also be exposed to much more credit and counter-party risk than they realize. And as Jeffrey Gundlach discussed at the recent DoubleLine Luncheon at the New York Yacht Club, “Never, ever take counterparty risk. It is the one risk you are almost never rewarded for taking. Unless you are running $800 billion dollars, there is no need to use swaps, synthetics or baskets – trade cash markets and avoid any trades that require a counterparty.”

(HistorySquared) “In light of the counter party risks inherent in ETFs, especially those that use synthetic swaps rather than the physicals, there might be an inexpensive way to express a bearish view on some of the European banks.

For example, in 2008 Lehman Brothers had several failed ETNs. ‘The three ETNs were Opta Lehman Commodity, Agriculture and Private Equity. In September 2008, these ETNs halted trading when Lehman Brothers failed. Currently, the final results are being sorted out, but it appears that Lehman ETN holders will receive 2 cents on the dollar from their original investment.’ ”

These are some clever lower-risk trading ideas for expressing a bearish view on the future solvency of a particular counterparty:

“Perhaps there are some far OTM options on some of the Socgen ETFs that are worth a look . Or a less risky trade could be long an ETF with physicals underlying the ETF that is issued by a more secure bank, and short the highly correlated Socgen ETFs. A potentially catastrophic event could be triggered by Deutsche Banks popular x-trackers.”

Full Story: ETFs as Tail Risk Trades (HistorySquared)

(Bloomberg) “ETFs that use swaps to clone stock, bond or currency returns have been criticized by regulators and firms including Fidelity Investors, which say clients risk losing money should the banks writing the derivatives become insolvent. Outflows from Lyxor are another blow to Societe Generale, France’s second-largest bank, whose shares have tumbled this year as the escalating sovereign-debt crisis squeezes lenders’ funding.

‘It’s an issue of counterparty risk related to the financial health of the backing bank,’ said Jose Garcia Zarate, an ETF analyst at Morningstar Inc. in London. ‘Fears over synthetic replication have been building up, and at the same time, fears of banks’ peripheral-debt exposure have grown. Put those two together: bingo!’ ” — Swap ETFs, Lyxor Have Record Outflows (Bloomberg)