Investing in Puerto Rican bond funds is no walk on the beach.

Photographer: Susana Gonzalez/Bloomberg.

UBS Made Some Suspicious Margin Loans in Puerto Rico

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Loosely speaking, what is meant by a "financial crisis" is that someone borrows money from someone else and can't pay it back, and it is socially or politically unacceptable that the people who loaned the money not get their money back. That last part is crucial: If someone borrows money and can't pay it back, and the lender loses money and no one else cares, then that's just capitalism, not a crisis.

QuickTake Puerto Rico's Slide

So part of the trouble in Puerto Rico -- which borrowed a lot of money and can't pay it back -- is figuring out how sympathetic the lenders are. The hedge funds telling Puerto Rico to close schools to pay them back: not hugely sympathetic. But the individual retirees, in Puerto Rico and elsewhere, who bought Puerto Rican municipal bonds because they were tax-free and supposedly safe, might be more appealing.  

If they are, that is a problem, because it means that money will need to be found to pay them back, and finding it in Puerto Rico's budget will be tough.  A federal bailout seems even tougher. There are other options. What about investment banks? If Puerto Rico sold bonds to people who didn't realize how risky those bonds were, a middleman was probably making the sales pitch. Some investment bank bought the bonds from Puerto Rico and sold them on to the widows and orphans, and if the widows and orphans can't get their money back from Puerto Rico, maybe they can get it back from the bank?

This is in some deep sense the purpose of investment banks. They "underwrite" bonds. They are necessary middlemen, trusted by both sides of the transaction to ensure that it's fair. At least in some imperfect and circumscribed way, they vouch for the issuer to the investors, and bear a moral, and sometimes legal, responsibility to those investors if those issuers fail.  

I say "the bank," though of course lots of banks were involved in selling Puerto Rico bonds to sympathetic investors in one form or another. But so far, wow, it sure looks like the bank is UBS? Way back in February, we discussed some UBS brokers who were told to push UBS funds that were full of Puerto Rican debt underwritten by UBS. That did not go well, and things have not improved since. Here's Bloomberg News last week:

UBS had a good thing going in Puerto Rico. The Swiss bank served as an adviser to the commonwealth’s Employees Retirement System, led the underwriting of a $2.9 billion bond issue for the pension agency in 2008, and then stuffed half of those bonds into a family of closed-end mutual funds it sold exclusively to customers on the island. It collected fees at every step.

The thing is going less good now. Investors are now "seeking more than $1.1 billion in damages from UBS after huge losses in the tax-free bond funds," according to Bloomberg, and they've had some wins.

The latest hit comes from the Securities and Exchange Commission, which on Tuesday sued a former UBS broker for misconduct in selling UBS Puerto Rican bond funds, and reached a $15 million settlement with UBS for failing to supervise him properly.  UBS will also pay $18.5 million in fines and restitution to the Financial Industry Regulatory Authority.

The SEC and Finra cases, though, aren't really about misleading investors about the risk of the bond funds. I mean, they're about that a little. According to the SEC complaint, the broker, Jose G. Ramirez, Jr., sold "approximately $50 million of certain UBSPR affiliated, non exchange-traded closed-end mutual funds ('CEFs')" to customers:

Ramirez misrepresented the true risk of the CEFs, and would instead refer to them as stable investments akin to bonds. Ramirez routinely told customers that their investments in CEF’s were so safe that "Plaza Las Americas will go bankrupt before anything happens to your money."

Ehh, that seems like just garden-variety puffery. They are akin to bonds. They are closed-end funds that invest mostly in Puerto Rico municipal bonds. They're portfolios of municipal bonds. Municipal bonds are supposed to be safe. It is not insane to think that a big mall in Puerto Rico would default before the Puerto Rican government would. Or maybe it's a little insane -- Puerto Rico's credit risks were not a secret! -- but it's not, like, a priori insane.

On the other hand the closed-end funds were "significantly leveraged, financing approximately 50% of their total assets," so anything bad for Puerto Rico's credit would be twice as bad for the funds. And was:

In 2013, the Puerto Rico bond market declined. The erosion caused a substantial decrease in the value of the CEFs, in part because the CEFs employed leverage up to 50 percent of the total CEF assets.

But that's not the main reason that UBS and Ramirez are in trouble. The bigger problem is that, on top of the leverage inherent in the closed-end funds, Ramirez also allegedly offered his customers additional leverage in the form of margin loans against their investments. So instead of investing $100 into a fund that levered up to buy $200 of Puerto Rican bonds, you could invest $100, borrow another $100, and put the $200 into a fund that bought $400 of Puerto Rican bonds. Meaning that anything bad for Puerto Rico's credit would be four times as bad for you.

Now, retail investors who took out margin loans to invest in risky securities are more or less the original politically sympathetic money-losers. Margin loans arguably caused the Great Depression! Since then, they have been heavily regulated. Banks and brokers are limited in how much margin leverage they can provide, and in what securities they can provide it against. In particular, margin is supposed to be limited to reasonably liquid stocks, and you can't give margin loans against non-marginable securities. The closed-end funds here "are not registered with the Commission, are not traded on any exchange or quoted on any quotation service, and are non-marginable securities."

But! Weirdly, although you can't give margin loans against non-margin securities, you can give non-margin loans against non-margin securities. The distinction is a little abstract. UBS couldn't lend you $100 so that you could go and buy $200 worth of its closed-end funds. That's an illegal margin loan. But it could notice that you had already bought $200 worth of its closed-end funds, and offer to lend you $100 for other purposes. That's fine.

Money is fungible, as they say, and those two transactions end up in exactly the same place. (You having $200 worth of bond fund, funded with $100 of your cash and $100 of UBS's.) But they feel different. In the legal version, you have to come up with the $200 first, and then later on maybe you borrow some money to refurbish your yacht without selling any bonds. In the illegal version, you come to UBS with your last $100 in the world, and it sends you home with $200 worth of risky stuff. Money might be fungible, but the order of operations matters.

So, according to the SEC complaint, UBS Puerto Rico offered non-margin loans to its brokerage customers:

In approximately 2003, BUSA, UBSPR’s banking affiliate, began offering UBSPR brokerage customers a line of credit that was “non-purpose” – meaning funds drawn under the LOC could not be used to purchase, carry, or trade securities – at no initial cost to the customer and at interest rates below those charged for margin loans. UBSPR offered BUSA’s LOCs to its customers to enable them to meet more of their financial needs through UBSPR instead of outside commercial banks.

UBS pushed the non-purpose lines of credit pretty hard, and paid its brokers for originating them. But it was careful to say that they weren't margin loans:

Internal UBS marketing materials stated that the purpose of the LOCs was to provide existing customers with liquidity and immediate access to cash in order to cover business expenses, acquire real estate, make certain periodic expense payments, or pay for luxury items without having to liquidate investment holdings, thus deferring capital gains.

UBSPR customers were prohibited from using LOC proceeds to purchase securities. UBSPR policy prohibited it, as did the customer’s LOC loan agreement with BUSA, which restricted the borrower from using the proceeds of any advance to purchase, carry or trade in securities.

You can see how Ramirez might have succumbed to temptation. Here's how the SEC says he succumbed:

Because customers could borrow money through their LOCs at rates as low as 1.5 percent and the CEFs were generating returns of greater than 6 percent, Ramirez saw an arbitrage opportunity for customers and an opportunity to increase his production and commissions if customers purchased additional CEF shares with the proceeds of LOCs. Ramirez presented this opportunity to customers as a way to make additional money by using the LOCs to increase their CEF holdings, notwithstanding his knowledge that UBSPR and BUSA prohibited customers from using the LOC proceeds to purchase securities.

In order to circumvent UBSPR’s policy against using LOCs to purchase securities, and evade detection of his scheme, Ramirez instructed customers to withdraw funds from their BUSA LOC accounts, deposit those funds into an account at another bank, wait several days, and then re-deposit the funds from the outside bank account into a UBS brokerage account, where the funds would then be used to purchase CEFs. This was despite Ramirez signing the Client Verification form attesting that he had explained to customers that they could not use LOC proceeds to purchase or carry securities.

Ramirez misrepresented to customers that they were not violating UBSPR policy as long as they first transferred the proceeds to an outside bank account. In several meetings with customers where Ramirez presented this strategy, Ramirez would take a dollar bill out of his wallet and say, “If I give you this dollar and you bring [another dollar] back next month, it’s not the same dollar.”

See? He knew the thing about money being fungible.  

Anyway, this was bad, the bonds lost value, the bond funds lost even more value, and the margined investors lost still more money. "Many of Ramirez's customers with LOCs collateralized by brokerage accounts holding CEFs began receiving maintenance calls," the SEC says, which made them sad and poorer. (A maintenance call is like a margin call, except you can't call it that, because the lines of credit weren't supposed to be margin loans. Either way, because the value of the collateral has fallen, the client has less equity, and the broker calls him up and demands more money.) 

You can see why UBS is in trouble for not catching this. That line of credit program, where your broker lends you money against your securities portfolio and then earnestly tells you not to spend it on more securities, sure sounds like it's ripe for abuse. And securities-based loans -- that is, non-margin margin loans -- have become increasingly popular. If those loans are really being used mostly by rich people to buy boats, then, I mean, fine, whatever, some rich people will lose their boats if the market crashes. But if the loans are in fact going to risk-averse retirees who've been pressured by their brokers into taking out loans to buy more risky financial products, then the consequences could be a lot more dire. After all, the margin rules grew out of the consequences of the crash of 1929. If we've forgotten those lessons, we might really be in trouble.

  1. Which I assume is why this thing called "Main Street Bondholders" exists, and calls criticisms of the hedge funds "an offensive attack against small investors, retirees and pensioners who have invested their life savings and pensions in Puerto Rican bonds."

  2. Opinions differ on how tough, but at some level of generality it's hard to deny that it will be tough. Puerto Rico does have a debt problem.

  3. Here again I am speaking very loosely indeed. The securities laws don't actually make underwriters liable for corporate failure, and contain due diligence defenses, and so forth. Still this is directionally more or less right: If an issuer sells very risky bonds to people who don't know the risks, there's a decent chance that the risks were misrepresented, and that the underwriter will be liable for the misrepresentations.

    Also, disclosure, or confession, or something: I used to be an investment banker, and I underwrote convertible bond deals. Some (not all!) convertible bond issuers are pretty risky credits. Investors know this. At least one or two of the companies I underwrote bonds for ended up in bankruptcy. I can't deny that this bugs me a little. 

  4. Technically the settlement is with UBS Financial Services Inc. of Puerto Rico. The SEC also settled with his former branch manager for $25,000.

  5. From the complaint:

    The CEFs are closed-end investment management companies incorporated under the laws of the Commonwealth of Puerto Rico and available only to Puerto Rico residents. Since 1995, UBSPR offered its customers twenty-three CEFs, for which UBSPR served as primary underwriter and as sole or co-manager. The CEFs are not registered with the Commission, are not traded on any exchange or quoted on any quotation service, and are non-marginable securities. UBSPR has been the only secondary market dealer or liquidity provider for the sole-managed Funds and the dominant dealer for several co-managed CEFs.

    Nearly all of the CEFs invest in similar securities. The CEFs’ investment portfolios are generally concentrated in Puerto Rico municipal bonds, which produce tax-free interest income, and the dividends the CEFs pay to their shareholders are tax-exempt to residents of Puerto Rico. Indeed, for eligibility for such tax benefits, CEF portfolios have to be comprised of at least 67% in Puerto Rico issuers. The CEFs are significantly leveraged, financing approximately 50% of their total assets, and thus, as a leveraged product, bear the concomitant level of risk.

  6. These numbers are made up; the SEC does not say how much leverage Ramirez's clients took out.

  7. Them or bank depositors. Really it's bank depositors, but retail margin borrowers are a close second.

  8. I do not, however, love the dollar bill performance. I feel like a good heuristic might be that if a financial product salesman takes out his wallet for any other reason than to buy you dinner, you should be skeptical.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor responsible for this story:
Zara Kessler at zkessler@bloomberg.net