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If Someone Offers You A Collared Swap On A Bank Trust Preferred Security, It's Okay To Say No

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The news these days is full of stories about swaps gone awry, where "awry" means "down in value for people who bet on rates going up, because rates went down." Oakland and Libor, yes, but there's a fun one in Floyd Norris's column last week about this horror:

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.*

Basically the Strats were made by the following formula:

  • take $25 worth of JPMorgan 5.85% trust preferred securities maturing in 2035,
  • replace the 5.85% coupon with a floating coupon of 3-month Treasuries + 100bps,
  • cap that floating coupon at 8% and floor it at 3%,
  • sell the resulting thing for $25,
  • hope for the best.

If you bought this thing - and, serious question, why would you buy this thing?** - the best didn't happen. The worst happened, or nearly: the worst you could do, outside of default, would be to get a 3% coupon for 30 years, instead of the 5.85% coupon that you'd get by just buying the JPMorgan TRUPS directly like a human.*** And with the 30-year treasury in the 2.6%-2.7% area, that's more or less what a Strat holder had to look forward to as of a month or two ago.

But life can always get worse, and it did for the Strat holders, because JPMorgan called the TRUPS in June. JPMorgan paid $25 for its TRUPS, and Wells Fargo is paying $14.69 for its Strats. Attentive Strat-holders have noticed that they got rather less than their $25 back and so are as expected hopping mad.

They got less than $25 back because Wells Fargo is charging them $10.69 as a termination payment on the collared swap that magicked their JPMorgan 5.85% TRUPS into a 3-to-8% floating-rate thing. They, and Floyd Norris, are agitated about how the prospectus didn't disclose this clearly enough, only saying "it is anticipated that any early termination payment to the Swap Counterparty would result in a loss to Certificateholders. This loss could be quite substantial in relation to the total value of the Certificates," but not translating "quite substantial" into numbers

Having sold derivatives I have some instinctive sympathies with the (no doubt long-departed) Wachovia structurer who built and underdisclosed this thing. This is not the first or last story you will see the form "unsophisticated investor expected free lunch, was charged for lunch, is mad." Here, the investors combined a JPMorgan 30-year preferred with a gamble on rates going up; since rates went down it should be no surprise that they lost money. How much money is the right amount of money for them to lose? Well, 5.85% of $25 is $1.46; 3% of $25 is $0.75; the difference is about $0.71 per year; there's 23 years left to scheduled maturity and 3-month Treasuries look to be under 2% for most of them; and 23 x $0.71 = $16.33. Present value, etc. etc., $10.69 seems okay.****

If you think like that then Wells doesn't come off too badly. They offered holders a gamble that would have improved the experience of holding JPMorgan TRUPS had rates gone up, while making distinctly less pleasant the experience of holding those TRUPS as rates went down. Their role was as middleman: that $10.69 a share they charged was not windfall to them but termination payment to their swaps counterparty, turtles all the way down. They disclosed the mechanics of how the unpleasantness would occur, albeit in a bit of legalese: as rates go down, (1) you will get a lower coupon, and (2) you might get called and lose the expected value of many years of lower coupons.

But who thinks like this? I fell down a bit of a rabbit hole of looking at the trading history of these things and the JPMorgan TRUPS; to simplify a bit, before JPMorgan called them the TRUPS traded at around par ($24-26 per $25 face amount) while the Strats were trading at around $21.***** This right there is ... wrong? The Strats consisted of (1) $25 worth of JPMorgan TRUPS and (2) a punch in the face on interest rates worth negative $10-15 in present value. So they were worth $10-$15, more or less, as a package, and traded at $21, because of hope and confusion and illiquidity.

And when JPMorgan called the TRUPS things got really weird: Norris points out "The price per share [of Strats] was $24.88 on July 12, when trading was halted as investors learned they would get just $14.69 a share. Trading never resumed." So they traded up after the call that crystallized their loss. The Strat holders thought that the early termination of their highly structured trade was a windfall for them. You don't need to know how swaps work to know: it's never a windfall for you. (It's often not a windfall for the bank even when it looks like one - offsetting swaps, etc. - but it's never a windfall for you.)

I feel a little bit for Wachovia/Wells. They probably thought this thing was pretty straightforward: you make money as rates go up, lose it as rates go down, and with a heart and a brain you can figure out how much you make or lose. And I'm sure they're indignant at the customers' complaints: why should those customers expect to make money when rates go up without risking anything on the downside? To a swap structurer used to dealing with sophisticated clients who understand the risks that they're taking on, it's easy to conclude that the disgruntled Strats buyers are greedy and stupid. But that proves a bit too much. If all the buyers of products like this are greedy and stupid, expecting upside but shocked shocked by downside - why are you selling them the products in the first place?

Buried in Details, a Warning to Investors [NYT]

* "A QUASI-ACRONYM." I'm going to be appending "a quasi-acronym" to a lot of things from here on out.

** I asked that question of the reader who brought it to my attention, whose response was "I’d bet that the phrase 'capture the upside!' was used frequently by the sales force."

*** Related: why would you buy a JPMorgan TRUPS?

**** Nah. Here is something that looks misleadingly more scientific:

By this math - which is wrong-ish, enjoy the mouseover if you dare! - Wells deserved about $9.28 per share, not $10.69, but I'm sure they knew what they were doing.

ALSO: I don't know nor care how $10.69 + $14.69 = $25.00. Accrued or something.

***** The underlying JPMorgan TRUPS thingy (CUSIP 46627VAA5 - the Strats are 78478Q101 if you're interested) last traded on June 29, at par. They traded between 99.5 and 100.135 after JPMorgan announced the call on June 12, and mostly around par in the year before that too - I guessed at the time that they were worth around par even ignoring JPMorgan's call right. (The TRUPS had a $100 par which I'm pretending is $25 for comparability.)

So basically you had the choice of buying something paying $1.46 for 23 years for $25, or buying something paying $0.75 a year for 23 years - with some upside! - for $21. I would pay the $25, which pays for itself in 5.6 years, but then I expect rates to stay low and JPMorgan to stick around for the next six years so reasonable minds could differ.