Muni Bond ‘Perfect Storm’ Now Over Island of Puerto Rico

It’s the peak of Hurricane Season, and tropical storms are churning in the Gulf of Mexico and threatening Louisiana and Texas.

Likewise, UBS clients on the island of the Commonwealth of Puerto Rico are waking up to a storm all their own; potentially hundreds of millions of dollars of losses due to highly touted, home grown Puerto Rican municipal bond funds.

Over the past several years, UBS, the leading Swiss investment bank, has had some issues with retail investor portfolios. This blog has frequently highlighted UBS’ problems.

First was the auction rates securities mess in 2008, followed by the Lehman Brothers structured products fiasco and then recently the Willow hedge fund that blew up.

The investments above were pitched to both the wealthy and Mom and Pop clients as safe, steady and low risk. In truth, they were loaded with risk and damaged legions of UBS clients by either freezing or wiping out investors’ principal. State and national securities regulators, in turn, have fined UBS tens of millions of dollars, but it seems those penalties have not motivated the bank to change its reckless ways.

Indeed, UBS in Puerto Rico has created, in the words of its head of wealth management, the “Perfect Storm” of a disaster in investor portfolios.

Over the past decade, UBS has sold roughly $10 billion of Puerto Rican debt, much of it packaged in its own proprietary closed-end funds. One series of such closed-ends is entitled the “Puerto Rican Fixed Income Funds.” Over the summer and into the fall, these closed-end UBS funds have cratered in value as the Puerto Rican economy has sunk in recent months.

Just last week, this blog underscored the markets’ current concerns for Puerto Rican municipal debt. Major brokerage firms, including, ironically, UBS, have recently warned their brokers to steer clear of the $70 billion of Puerto Rican debt currently clogging the market.

For UBS, this presents a particularly nasty turn of events, as noted by Susanne Craig last week in the New York Times. Puerto Rico is struggling with a weak economy, rising interest rates and outsized debt loads.

“The bank’s clients had piled into highly leveraged bond funds run by UBS and were encouraged by its brokers to borrow even more money to invest in those funds,” Craig reported. “In some cases, money was lent improperly, exacerbating current losses, according to UBS employees in the region.”

She continued: “Now, a number of UBS clients have been forced to liquidate hundreds of millions of dollars in holdings in these funds to meet margin calls. And the bank says it has begun an internal investigation into the lending practices of some of its top-producing brokers.”

This should not come as a surprise. Municipal Bond default warnings have been loud and clear for several years, particularly from Meredith Whitney, a top analyst who correctly called the market devastation created by investment banks in 2008. She’s been leading the charge to alert investors to the risks of investing in purportedly safe, income paying municipal bond products.

Investors who relied on the income from Puerto Rican bond funds to pay for their retirement needs have now awoken to a category five hurricane. In addition to having risky credit and being based on a concentration of Puerto Rican securities, investors have now learned that UBS leveraged the funds by over 53% which, when they declined in value, exacerbated the problem. As Bruce Kelly of InvestmentNews in a report on the UBS Puerto Rico municipal bond fund disaster noted: “Leverage on such investments can magnify such losses.” Municipal bond funds domiciled in the United States are allowed to use only about half as much leverage as those in Puerto Rico, Kelly reported.

Many UBS investors were pushed by their brokers to buy the bonds and also to use them to secure credit lines on their homes and on their brokerage accounts, according to these two reports. Once the bond values came crashing down, with the leverage enhancing the losses, investors have been crushed and many will lose their retirement savings and their homes.

It isn’t often that a bank creates its own manmade “Perfect Storm,” but UBS seems to have a habit of doing so. No one can send in the Red Cross to bail out UBS investors hammered by this storm. When will UBS do the hard work to change its culture and put their clients before the fees the bank collects on such over-leveraged, high risk products like Puerto Rico closed-end bond funds?

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