The intro paragraph of a New York Times story says it all: “The bank that put together the unusual security did well. The customers who bought it suffered large losses. No one – at least no one who traded the security – seems to have understood the risks that were hidden deep in the prospectus.”
The security in question was a Wells Fargo security that had a lengthy and convoluted name: Floating Rate Structured Repackaged Asset-Backed Trust Securities Certificates, Series 2005-2). Like its cumbersome name, the security was highly complex and hard to understand.
It was created and sold in 2005 by Wachovia Securities, then part of Wachovia Bank and later renamed Wells Fargo Advisors after Wells Fargo acquired Wachovia. Clients of Wachovia Securities/Wells Fargo purchased approximately $28 million of the Floating Rate Structured Repackaged Asset-Backed Trust Securities Certificates, Series 2005-2 securities, which went by the nickname of Strats.
Investors thought they were buying an investment that offered a modest but safe yield. They would later learn otherwise.
Strats was marketed in $25 units, and investors were promised monthly interest payments for as long as 30 years. At that time, investors would get the $25 back. Those interest payments would fluctuate with interest rates on Treasury Bills, but they could not go below 3% a year or above 8%.
Wells Fargo now says if investors had only read the prospectus they would have known that disaster was forthcoming in June, when news related to the security was disclosed. But that disclosure actually had the opposite effect on the market. In New York Stock Exchange trading, the price of Strats rose 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.
That’s because Wells Fargo received $10.69 a share as compensation for the profits it would have made over the next 23 years had the security not been redeemed.
If that wasn’t bad enough, underlying Strats was another security – a trust preferred security issued by JP Morgan. Investors in Strats now not only owned a proportionate amount of the JP Morgan security, but they also were counter parties to Wells Fargo in an interest-rate swap.
Wells would collect the 5.85% coupon from JPMorgan and pay out 3 to 8% interest to investors in the security. The bank would suffer if interest rates went up, and profit if they fell. If JPMorgan redeemed the security when rates were low, Strat investors would have to pay to terminate the hedge.
That information was disclosed on Page S-12 of a supplement to the prospectus. Specifically, it warned investors that “this loss could be quite substantial.” Wells Fargo thinks that minute warning served as an adequate disclosure, despite the fact that no examples were provided to illustrate exactly how devastating the termination payment would be for investors.
When the redemption did take place, JPMorgan paid out the equivalent of $25.6541 per Strat share, including some accrued interest. Wells Fargo kept $10.9683 to compensate it for the early cancellation of the interest- rate swap, and paid out what was left, $14.6857, to the public investors.
Investors, meanwhile, paid the ultimate price. For those who owned the security since its creation in 2005, they received about $6.70 in interest per share and a capital loss of $10.31.
“It was a very conservative security,” said one investor, a professor, in the New York Times story. Like many investors in Strats, the professor (who wished to remain anonymous for the NYT article) lost money on an investment that was supposed to be “a very nice, Grandma type” of security. He says the prospectus never made the risks clear. If it had, he would have invested his money elsewhere.