UBS’s Puerto Rico Bond Funds Implode, “Collateral Value” Drops to Zero, Investors Screwed

TDC Note – Is this what is causing the “markets” to act so strange and has all the Wall St criminals so nervous? by Wolf Richter, Wolf Street

“We believe that the probability of default is approaching 100 percent, and that losses given default are substantial,” Moody’s wrote on Wednesday about Puerto Rico’s $72 billion in bonds that were stuffed into numerous conservative-sounding bond funds spread across America’s retirement portfolios.

“Bondholder recoveries will be lowest on securities lacking explicit contractual or other legal protections,” the report went on, according to Bloomberg. About $26 billion in bonds fall into this category, issued by entities such as the Government Development Bank, Highways and Transportation Authority, Infrastructure Finance Authority, and Municipal Finance Authority. Investors in these bonds might recover only 35 cents on the dollar.

Recovery rates for bonds with stronger investor protections, such as general obligation bonds, would likely range from 65% to 80%, Moody’s said.

But those recovery rates, as dire as they seem, only apply if you own the bonds outright. If you own those bonds in a bond fund, the scenario may look much, much worse, according to what UBS just did.

Turns out, some of these bonds were underwritten by UBS and stuffed with other Puerto Rico bonds into its own Puerto Rico closed-end bond funds and sold to its own unsuspecting clients. These funds aren’t traded; UBS sets the value.

And UBS, despite the well-known problems Puerto Rico has been having for years, wasn’t shy about loading up its clients up with these bonds, apparently, according to Reuters:

Many UBS brokers had misgivings about the funds even as UBS’ Puerto Rico chairman was pushing them to sell the bonds, according to a voice recording, reported by Reuters in February.

And then there was leverage, as recommended by UBS brokers because UBS profits even more, not only in selling the bond funds but also in lending the money:

Many of those investors bought even more fund shares with money they borrowed through credit lines from another UBS unit, after several UBS brokers may have improperly advised them to do so, according to a $5.2 million settlement between UBS and Puerto Rico’s financial regulator in 2014.

Since the collapse of Puerto Rico bonds, the funds have become “legal headaches for the firm,” as Reuters put it, with the FBI “investigating allegations about UBS’ sales practices that touted the funds’ high yields and tax advantages.”

OK, looks like these funds have become a sordid business. But as unlikely as it may seem, they just now got even more sordid:

UBS sent out a letter to its clients on July 13, and at least one of those incensed recipients must have leaked a copy to Reuters. In this letter, UBS said that it “will also reduce to zero the collateral value assigned to all Puerto Rico closed-end funds shares.”

To zero!

Clients were warned that they can no longer use these funds as collateral for loans, even those loans they used to buy these funds with in the first place.

That’s how risky UBS thinks these bond funds are. But UBS sets the value of these funds, and for now, they still have “value,” at least on its website, according to Reuters: “For example, one of the riskiest funds was worth $3.46 per share as of Thursday….”

By having the collateral value of their bond funds cut to zero, these clients are looking at a potentially grim situation:

Jeffrey Sonn, a lawyer in Florida, who represents some of the investors, told Reuters that UBS might liquidate the assets of clients who used these Puerto Rico bond funds as collateral for loans and might even take legal actions against them if they fail to produce additional collateral to replace the funds.

This would nicely top off the sordidness of all this, given how much money these clients have already lost on these bond funds. Consequences?

Lisa Bragança, a lawyer for Stoltmann Law Offices in Chicago which represents some of the investors, said the admission that the collateral value of these funds is now zero could bring on more investor arbitration claims against UBS, on top of the hundreds that have already been filed.

“This is a real pickle for UBS to say the collateral value assigned to the closed-end fund shares is zero,” Bragança said.

By doing so, UBS is effectively admitting that it sold a bad product and that the funds are too risky for the firm itself, let alone average investors, lawyers said.

So the lawyers are going to get rich. UBS clients might eventually recover a small portion of their original investment and weep over the rest. And UBS will simply brush off the outcome as another “charge from legal settlements,” or something similar, one more in many, and exclude it from its adjusted, pro-forma, non-GAAP, ex-items EPS number, which is all that matters to the hype mongers that analysts have become. And life goes on.

It all boils down to finding the perfect wealth transfer method. JP Morgan did. Read… “Leveraged Loan” Time Bomb Goes Off

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