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For centuries, Wells Fargo (NYSE: WFC) has put its reputation above all else.
The San Francisco-based banking giant appeared to emerge relatively unscathed from the 2008 financial crisis. It was named Most Valuable Bank Brand in the United States and number two worldwide in 2012.
It has avoided the reputation of being manipulative, like its rivals – but that doesn't mean investors aren't getting burned.
An article last week from The New York Times showed that investors need to fully understand the risks of their investments, and can't always trust their bank – no matter the reputation – to look out for them.
Turns out investors who purchased an unusual security suffered steep losses, while Wells Fargo came out ahead. The risks, and there were many, were deeply hidden in the prospectus, a wordy and complicated document few investors understood.
Wells Fargo (NYSE: WFC) and Strats
The issues is an uncommon security, Floating Rate Structured Repackaged Asset Backed Trust Certificates, Series 2005-2 (or Strats, for short).
Strats were first sold by Wachovia Securities. Wells Fargo bought ailing Wachovia in 2009, as it teetered on bankruptcy after a slew of mismanaged and over-reached acquisitions.
While Strats were complex, their advantages seemed simple to investors.
Strats were marketed in units of $25, an attractive price point for debt-like securities targeted to individual investors. The enticing sales pitch was that they guaranteed monthly interest payments for as long as 30 years, at which time the investor would receive their principal payment back. The promised interest payments would fluctuate with interest rates on Treasury bills, but would not go lower than 3% or greater than 8%.
It wasn't a huge security in comparison to other Wall Street equity and debt offerings – only $28 million in shares were outstanding when it stopped trading this summer.
But the problem was – and something few investors understood – that Strats had an underlying security and a complicated arrangement set up with that investment.
In a complex swap arrangement, investors in the Wells Fargo Strats also owned a comparable amount of a "trust security" issued by JPMorgan Chase (NYSE: JPM). JPM had sold its security to institutional investors.
Wells Fargo had also engaged in an interest-rate swap with JPMorgan. Wells Fargo would collect a 5.85% coupon from JPM and pay out the 3% to 8% interest to investors. If interest rates were up, Wells would suffer, but would profit if they fell.
JPM was not allowed to redeem the security early – unless capital rules changed, which they did thanks to the Dodd-Frank law. So JPM decided to redeem at face value and announced its plan on June 11.
On July 12, Strats shares were trading at $24.88 before being halted as fresh news was broadcast that investors would only get $14.69 a share, not the $25 per share as assured. Trading never resumed.
JPMorgan paid out $25.6541 per Strats upon redemption, of which Wells Fargo retained $10.963 as compensation for the early termination, and paid the remaining $14.6857 to retail investors.
That means investors who bought the share in 2005 when it was created received about $6.70 in interest per share, but lost $10.31 per share in capital.
Quite a loss for something that one investor told The Times he thought was a "nice, Grandma type" of investment.
Wells Fargo, meanwhile, collected $3.32 per Strat share from JPMorgan – after it paid investors – and plus $10.97 per share for the cancellation.
Wells Fargo said in its defense that anyone who read the prospectus would have been able to spot the risks forming in a low-interest rate environment. With Wells Fargo retail customers holding about $2 million in Strats when the shares were redeemed, clearly none of them had understood what was on page S-12 of the prospectus supplement.
A Wells Fargo spokeswoman told The Times that WFC didn't profit at all, due to some hedge maneuvers.
"Substantially all of that payment was used in connection with unwinding hedges," Wells Fargo's Elise Wilkinson told The Times.
Lawyer and blogger Ed Hall, who has written on Strats and brought the security to the attention of The Times, said it is obvious that investors had no inkling or understanding of the risks.
"Wells needed to place a clear warning at the start of the prospectus, rather than buried deep in the prospectus," said Hall.
In all likelihood, the disclosures submerged in the prospectus complied with securities law, so lawsuits, if any, will most likely have no merit. But Wells Fargo walked away with deeper pockets, and investors lost out.
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