Here are phrases you will be hearing a lot of in the next few months: first, second, third, fourth, fifth, etc. order effects. Case in point: UBS sells bond funds that buy Puerto Rico municipal bonds, some of which UBS underwrote. Puerto Rico is deep in the hole and probably won’t make payment on some of the bonds. That’s the first order effect. Some of UBS’s customers have borrowed money using their bond funds as collateral. That’s the second order effect. UBS has just told its customer that it has marked their collateral down to zero, which means they can no longer borrow against those bond funds. The customers have to either come up with more money or sell their bond funds, almost certainly at a loss. That’s a third order effect. The diminution in their net worth may reduce their consumption, saving, investment, or, in extreme cases, their ability to pay their creditors, fourth order effects. And that’s how defaults unravel daisy chains of debt. From Wolf Richter, at wolfstreet.com:
“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.
To continue reading: UBS’s Puerto Rico Bond Funds Implode
