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 not a large one by Wall Street standards, and it is possible that it would have worked out well for both the bank and its customers if the Dodd-Frank law had not changed the way banks calculate their capital. But it is illustrative of what can happen when a security is packaged by a firm that intends to have a contrary interest from its customers for the life of the security, and that does not clearly explain what could go wrong.
It also shows how markets can fail. Perhaps because only $28 million worth of the security was outstanding and had been primarily sold only to customers of a small number of firms, there does not seem to have been anyone watching the trading this summer who understood the disaster that was about to befall the investors who had sought safety and assured income and wound up with a large capital loss.
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.
The security had a mouthful of a name: Floating Rate Structured Repackaged Asset-Backed Trust Securities Certificates, Series 2005-2. It was created and sold in 2005 by Wachovia Securities, then part of Wachovia Bank, which was renamed Wells Fargo Advisors after Wells Fargo acquired Wachovia. The bank called the securities Strats, a quasi-acronym.
Underlying that security was another one, a “trust preferred” security issued by JPMorgan Chase and sold to institutional investors. That security paid annual interest of 5.85 percent and matured in 2035. Trust preferreds were hybrid securities that appealed to banks because bank regulators treated them as capital but the Internal Revenue Service allowed banks to deduct the interest paid.
JPMorgan could not redeem the security early — unless tax laws or bank capital rules changed. But when the capital rules were changed by the Dodd-Frank law, JPMorgan gained the right to redeem the security at face value, something it was all but sure to do given the current low level of interest rates. On June 11, it announced plans for the redemption.