Floyd Norris of the NY Times wrote a piece on how big banks hosed retail investors on a complicated security. Of course, the bank does not see it this way. The bank in question is Wells Fargo whiach actually inherited this security from its acquisition of Wachovia which actually was the lead underwriter back in 2005. Here is the article:
This is another reason retail investors don’t trust the stock markets or banks and brokers. Libor scandals, muni bid rigging scandals, robo signings, the 2008 meltdown, the Flash crash, the Knight trading debacle yesterday and on and on.
I don’t believe retail investors got taken advantage of in Facebook. In Facebook, they got done in by their own greed and media hype and was just another mania they decided to participate in like the internet bubble or housing. People who heeded my warnings on the Facebook IPO in February would never have had a problem:
I know a lot about trust preferred securities as I was working at one of the largest institutional investors in the country when these were invented and we bought a lot of them. The problem is not trust preferred securities (TPS) although these complex instruments would not exist if we got rid of rating agencies and the corporate income tax. The Wachovia issue was a derivative based on the underlying TPS using an interest rate swap agreement. TPS are usually sold to institutional investors, though they often might trade in the secondary market on the NYSE allowing retail investors to purchase them.
Investors who would have purchased the actual TPS issued by JP Morgan would have gotten an interest payment that was at the mid-point of the Wachovia security which was designed to have a floating rate. The real difference is the investors in the underlying JP Morgan TPS got all their principal bank, where the Wachovia security holders lost 40% of their principal. Would any rational investor take a risk of a 40% loss, just to at “best case” get roughly 300 basis points more than the underlying security and possibly even a lower interest rate? Of course not and certainly most retail investors would not who invest in fixed income securities .
While the NY Times article and the blogs it links to have a lot of focus on whether the disclosure of risks was adequate and I think it was not – it is not even the largest issue. The larger issue is that brokerage firms cannot by regulation sell “unsuitable” securities. For example, at an extreme it not permissible to allow a 90 year old living on a fixed income to sell naked calls. Nor is it permissible to put someone who wants to invest for income in penny stocks.
Everyone in the industry knows the retail investors don’t read prospectuses – actually either do many institutional investors. People are time constrained, they have neither the time nor patience to read long wordy documents and the retail investor would not even understand it if they read them. They rely on how the broker pitches the sale. I guarantee you people who bought this understood only that the rate could float, the length of maturity and that is was “Wachovia”. The retail investor is thinking Wachovia – they are a big outfit, my money is safe and I will get in back. Never in a million years did retail investors understand the underlying mechanics of this security.
When the auction rate securities market blew up, regulators made firms make their investors whole in spite of the prospectus because it was pitched as a money market alternative, which it wasn’t. Regulators should act here – they should make Wells Fargo make the investors whole. It does not even matter whether Wells made money on the redemption or not and whether they had legitimate costs to unwind the hedge. Wachovia for which they assumed the liabilities of, never should have brought this issue to market – particulary being sold to retail investors – it was simply too complicated for them to understand. In Wachovia’s defense they probably thought a triggering event for a redemption might be like a 100 year flood, but nonetheless – it is by its structure and complexity and even risk/reward, an unsuitable security to whom it was originally sold and hence they should make good on them.