What Is a Structured Repackaged Asset-Backed Trust Security?
A structured repackaged asset-backed trust security (STRATS) is a derivative product that pays income based upon a trust's interest in an asset-backed security and a related derivative product.
Understanding Structured Repackaged Asset-Backed Trust Securities (STRATS)
Structured Repackaged Asset-Backed Trust Securities (STRATS) were developed by Wachovia in 2005. Investors who purchase STRATS technically buy shares of a trust, which pays investors income based upon a combination of the trust's interest in a capital security and a derivative product. The complexity of the name offers an indication of the complexity of the underlying product.
Structured products combine investments in traditional securities with a derivative component in order to generate a more customized set of investment risks and returns than an investor would find investing in a traditional security alone. Investors who prefer structured products generally have highly specific needs not easily met by a more conventional financial instrument.
Repackaged products allow investment firms to resell existing assets or securities in a different form. In the case of STRATS, a trust repackages asset-backed securities, which consist of bonds or notes backed by an underlying asset. The trust then combines those securities with a derivative, typically an interest rate swap used to hedge against interest rate risk in the security component. The trust bases its payments to investors on the income streams derived from the two components.
Wells Fargo's Controversial STRATS Issue
In 2012, the Financial Industry Regulatory Authority (FINRA) fined Wells Fargo Advisors due to recommendations it made to investors regarding a series of floating-rate STRATS whose value dropped precipitously. The STRATS in question concerned a combination of a trust-preferred security issued by JPMorgan Chase and an interest rate swap designed to hedge the security’s exposure to rate changes. Although the prospectus for the STRATS series contained a warning about substantial losses if JPMorgan redeemed the security early, the bank allegedly marketed the product as a conservative investment. After Wells Fargo retained a portion of JPMorgan’s payoff as compensation for the early cancellation of the interest rate swap, in which JPMorgan also served as a counterparty, investors took a substantial loss on their shares.
While Wells Fargo insisted the prospectus for the product contained sufficient warning for investors, FINRA determined the firm had failed to train its brokers about the risks inherent in the product. Some experts argued at the time that Wells Fargo should have made its warnings about the risk more prominent in its prospectus. To avoid such negative surprises, retail investors should always research investment products to ensure they understand all their elements and read the prospectus carefully before committing to an investment.