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FINRA: Santander Failed to Update Risk on Puerto Rico Munis - See Our Suitability Matrix

Posted by Jack Duval

Oct 14, 2015 10:37:00 AM

santander

Yesterday FINRA announced a $6.4 million fine and Acceptance, Waiver and Consent by Santander for sales practice and supervisory violations at its Puerto Rico offices.  (FINRA Press Release and Santander AWC - search under Case Number: 2014041355501)

The AWC and sanctions revolve around a number of failures to supervise the sales of Puerto Rico municipal bonds and closed-end funds.  The AWC highlights a number of supervisory failures, including:

  • The failure of Santander to update its proprietary risk-classification tool for the unique and changing risks of Puerto Rico municipal bonds; (See our Suitability Matrix, below.)
  • The failure to monitor for the use of margin in connection with the purchase of Puerto Rico municipal bonds;
  • The failure to monitor for over-concentrated positions in Puerto Rico municipal bonds and closed-end funds;
  • The failure to monitor for Registered Representatives selling personal Puerto Rico municipal bond holdings to their clients. 

The "Securities Master"

Santander used a proprietary risk-classification tool that categorized securities into three risk levels: low, moderate, and high.  The AWC noted the "vast majority of Santander's clients were moderate-risk investors" and that almost all the Puerto Rico municipal bonds sold to their clients were coded moderate-risk.  However, Santander did not update the Securities Master to reflect the dramatically increasing risks in the Puerto Rico municipal bond market.

The FINRA press release stated:

Santander did not review or assess the tool's Puerto Rico municipal bond risk classifications following significant market events such as the December 13, 2012, Moody's downgrade of certain (bonds) to one level above junk.

Santander and its Registered Representatives Sold Their Puerto Rico Municipal Bonds While Customers Held or Purchased Them

While Santander was holding its moderate risk classification steady for Puerto Rico municipal bonds, it was reducing it's trading desk inventory.  The AWC states:

On November 29, 2012, Santander began reducing its Puerto Rico municipal bond inventory.  (The December 13, 2012 Moody's downgrade) acceleranted the Firm's efforts to reduce its inventory of Puerto Rico municipal bonds, reflecting Santander's concerns about changed risks in the market for Puerto Rico municpial bonds and Santander's exposure to those risks.

The next day, on December 14, 2012, Santander closed its Puerto Rico trading desk to any new purchases of Puerto Rico municipal bonds... The Firm, however, continued to reduce its market exposure and entirely eliminated its inventory of Puerto Rico municipal bonds by October 2013.

... employees sold securities directly from their accounts to customer accounts.

Sanctions

FINRAs sanctions include:

  • A centure;
  • A fine of $2 million;
  • Restitution of approximately $4.3 million.

Analysis

The most significant finding in the AWC is that Santander failed to update it's risk-classification for Puerto Rico municipal bonds in the face of overwhelming evidence that the economy had been in a long-term decline, and the fact that the bonds had been downgraded a number of times.  (Puerto Rico GO bonds were downgraded on 8/8/11, 12/13/12, and 3/13/13.)

These increasing risks made the bonds less and less suitable for investors going back to the beginning of the economic decline in 2006.

The Accelerant Puerto Rico Municipal Bond Suitability Matrix

Accelerant has created a suitability matrix showing how Puerto Rico municipal bonds became more risky and less suitable over time.  It provides a framework for evaluating the suitability of client positions in Puerto Rico municipal bonds, by level of client account concentration. Key features:

  • Identifies three distinct phases of increasing risks in Puerto Rico municipal bonds;
  • Highlights two milestones where continuing to hold the bonds required higher risk tolerances or lower allocations;
  • Provides a clear and consistent method for evaluating damage claims.

For a high resolution version of the Suitability Matrix, go here.

The_Accelerant_Puerto_Rico_Changing_Suitability_Matrix

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For information about Puerto Rico municipal bonds expert Jack Duval, click here.

For my previous coverage of the Puerto Rico municipal bond crisis, see this.

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Topics: municipal bond crisis, FINRA, closed-end funds, Puerto Rico, UBS, supervision, securities litigation, Compliance, Santander

UBS Hit with $34 Million in Fines over Puerto Rico Funds

Posted by Jack Duval

Sep 29, 2015 4:29:00 PM

UBS_Puerto_Rico

FINRA and the SEC just announced a $34 million fine against UBS for its Puerto Rico funds.  You can find the announcement here.

For the full AWC, see this.

We will have more analysis later.

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For information about Puerto Rico municipal bonds expert Jack Duval, click here.

For my previous coverage of the Puerto Rico municipal bond crisis, see this.

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Topics: municipal bond crisis, FINRA, closed-end funds, Puerto Rico, UBS, SEC, securities litigation

Puerto Rico Debt Crisis Puts Focus on Insurers

Posted by Jack Duval

Jul 14, 2015 10:02:00 AM

To access our analysis of Puerto Rico bonds by insurer, see this.

PR_Bond_Image

 

The July 28th, 2015 Puerto Rico debt restructuring announcement by Governor Padilla should have come as a surprise to no one.  However, the stocks of the insurers standing behind more than $11.8 billion of Puerto Rico municipal bonds have declined significantly since then.

We have analyzed the bonds of the largest Puerto Rico bond issuers and compared the prices of similar issues with different insurers.  The difference is striking.  National, Assured, and AMBAC appear to have the market's confidence, while CIFG, XLCA, and FGIC do not.

Simply put, the market appears to be pricing in the certainty of a restructuring/reorganization/default and is looking through the bonds to the insurers.

You can access our analysis here.

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For information about securities expert Jack Duval, click here.

For my previous coverage of the Puerto Rico municipal bond crisis, see this.

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Topics: municipal bond crisis, closed-end funds, Puerto Rico, UBS, securities litigation, municipal bond insurance

Accelerant Publishes Guide to Puerto Rico Capital Structure

Posted by Jack Duval

Jul 1, 2015 11:29:00 AM

Accelerant has published a guide to the Puerto Rico municipal bond capital structure.  The guide covers:

  • The largest Puerto Rico issuers;
  • Amount outstanding;
  • Primary security source;
  • Government backing;
  • If "local" bonds have been issued;
  • Taxation to U.S. and P.R. residents;
  • Insurance;
  • Ratings;
  • The price on or before June 26, 2015.

To access the guide, please click here.

This guide is designed to help market participants and securities litigators better understand the outstanding debt of the Commonwealth, its agencies, and other issuers.

Chart of Puerto Rico General Obligation Bond (trading at 55.375)

Puero_Rico_GO_Municipal_Bond

 

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For information about securities expert Jack Duval, click here.

For my previous coverage of the Puerto Rico municipal bond crisis, see this.

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Topics: municipal bond crisis, closed-end funds, Puerto Rico, UBS, securities litigation, Puerto Rico Municipal Bond Capital Structure

Puerto Rico to Default/Reorg/Restructure Municipal Bond Debt

Posted by Jack Duval

Jun 28, 2015 9:15:00 PM

Puerto Rico Governor Garcia Padilla today admitted what has been obvious for years:  the Commonwealth cannot pay its debts and will look to reorganize, restructure, or default on some or all of its $72 billion in outstanding municipal bonds (including general obligation bonds).  The Governor will release an IMF Stability Anaysis tomorrow and will make a televised speech about the fiscal crisis at night.

As we have covered extensively, this outcome was inevitable, and obvious.  This is good news for the island economy as it will allow it to hit the "reset" button.  In the near term, the economic pain will continue, but in the long term, the dead wood will be cleared and new growth will emerge.

This is not good news for owners of Puerto Rico municipal bonds, many of whom own the debt directly, and others who own it indirectly, through open and closed-end municipal bonds funds.  Almost any scenario will most likely invovle severe haircuts on the amount owed (i.e. your $1,000 face value bond is now a $400 face value bond) and/or payment extensions (i.e. your five year bond is now a 20 year bond).

With Greece closing its banks and stock market and imposing other capital controls tomorrow, it looks to be an interesting day for the markets.

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For information about securities expert Jack Duval, click here.

For my previous coverage of the Puerto Rico municipal bond crisis, see this.

 

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Topics: municipal bond crisis, closed-end funds, Puerto Rico, UBS, securities litigation

Former Brokers Sue UBS of Puerto Rico

Posted by Jack Duval

Apr 16, 2015 7:26:00 AM

UBS

Two former UBS brokers, George and Tresa Bravo, are suing UBS Puerto Rico for "deceiving employees and customers about closed-end mutual funds".  (Emphasis added. My paraphrasing of the google translation from Sincommillas.com.)

The brokers, who have 30 years of industry experience and managed over $120 million of client assets, are alleging that UBS "threatened, deceived, and coerced" them regarding UBS's proprietary municipal bond closed-end funds, most of which used leverage.

If true, it would appear that it is another case of brokerage firms selling complex products that are not properly understood by the firm's management, salesmen, or clients.  I have examined this phenomenon at length in my white paper: Complexity Risk: A New Risk Category.

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For information about securities expert Jack Duval, click here.

For my previous coverage of the Puerto Rico municipal bond crisis, see this.

 

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Topics: municipal bond crisis, closed-end funds, Puerto Rico, UBS, securities litigation, Complex Investments, Complexity Risk

Fitch Downgrades Puerto Rico GO Debt to B - Watch Negative

Posted by Jack Duval

Mar 26, 2015 3:09:00 PM

fitchratings

Yahoo! News reports the following affected credits:

With today's action, Fitch has downgraded and placed on Rating Watch Negative all of the following ratings:

--$13 billion Commonwealth of Puerto Rico GO bonds, downgraded to 'B' from 'BB-'

--$6.7 billion Puerto Rico Sales Tax Financing Corporation (COFINA) senior lien sales tax revenue bonds and $8.5 billion COFINA first subordinate lien sales tax revenue bonds, downgraded to 'B' from 'BB-'

COFINA bonds have a security interest in and are payable from the Commonwealth's sales and use tax. COFINA is an independent governmental instrumentality of the Commonwealth and affiliate of the GDB established by specific legislation. The COFINA bonds are rated at the level of the Commonwealth's general credit. Although COFINA bonds were specifically excluded in the Public Corporation Debt Enforcement and Recovery Act, the passage of the Act substantially increased Fitch's assessment of the risk that the Commonwealth may take steps to the detriment of COFINA bondholders if the Commonwealth considered that a fiscal emergency and its need to provide essential services required legislative action limiting revenues available to COFINA. Fitch does not place COFINA debt below the Commonwealth's GO as the agency believes that if circumstances warranted a shift in COFINA revenues to fund the general government, the GO bonds would be equally likely to default. There is no rating distinction between the senior and subordinate COFINA liens, as the legal security of each would warrant a higher rating in the absence of Commonwealth risk factors.

--$2.9 billion Employees Retirement System of the Commonwealth of Puerto Rico (ERS) pension funding bonds, downgraded to 'B' from 'BB-'

The ERS bonds are a limited, non-recourse obligation of the pension system, payable from and secured by a pledge of statutorily required employer contributions to the system. The rating on the ERS bonds is the same as that assigned to the Commonwealth's GO bonds, as the Commonwealth is the largest employer contributor and contributions have a strong legal priority. Given that GO bondholders have a legal claim on Commonwealth revenues senior to contributions due to the pension systems, the rating on the ERS bonds can be no higher than the Commonwealth GO rating.

--$1.4 billion Puerto Rico Public Building Authority (PBA) government facilities revenue bonds guaranteed by the Commonwealth and rated by Fitch and $658 million PRASA Commonwealth guaranty revenue bonds, downgraded to 'B' from 'BB-'

Bonds of the PBA and PRASA that are guaranteed by the Commonwealth are backed by the Commonwealth's commitment to draw from any funds available in the treasury. The good faith and credit of the Commonwealth is pledged to any such deficiency payments, resulting in a rating that is the same as the Commonwealth's GO bonds.

--$3.4 billion PRASA senior lien revenue bonds, downgraded to 'B' from 'B+', Rating Watch Negative maintained

PRASA's revenue bonds likely will be influenced by movement of the Commonwealth general obligation rating for the foreseeable future given the Commonwealth's historical actions and ability to expose PRASA to potential fiscal and operational challenges.

Fitch does not rate any other appropriation- or special tax-secured debt of the Commonwealth.

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For information about securities expert Jack Duval, click here.

For my previous coverage of the Puerto Rico municipal bond crisis, see this.

 

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Topics: municipal bond crisis, closed-end funds, Puerto Rico, UBS, securities litigation

Jack Duval Publishes Company Town Investing White Paper

Posted by Jack Duval

Mar 11, 2015 4:33:37 PM

I am pleased to announce the publishing of a new white paper: "Company Town Investing: The Case of Puerto Rico."

PuertoRicoMuniBondCrisis

This paper examines a risk that is commonly missed by financial advisors: that of common exposures across an investor’s total wealth.  I call this phenomenon "Company Town" risk, harkening back to the small towns that sprang up around a local mill, mine, or factory.  As those who have lived in Detroit could attest, the company town exists today.

In this paper, I use Puerto Rico as an exemplar of the modern company town.  I show how the island became dependant upon the Section 936 U.S. tax incentive, and how it's expiration sent Puerto Rico into a brutal secular decline.

Furthermore, I show that if Puerto Rico residents had been diversified away from Puerto Rico exposed investments, they would have done very well through the economic decline.  This will be of particular interest to those attorneys with municipal bond cases in Puerto Rico.

Paper sections include:

  • Puerto Rico - A Company Town with One Large Exposure
  • Section 262 and 936 Tax Incentives
  • Statistical Evidence of Section 936 Impact on Puerto Rico Growth
  • Correlations of Puerto Rico Total Wealth
  • Investing for Company Town Residents

Click to Download: Company Town Investing - The Case of Puerto Rico

To learn more about author Jack Duval, click here.

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Topics: municipal bond crisis, closed-end funds, Puerto Rico, UBS, securities litigation, Company Town, Total Wealth Diversification

Puerto Rico: Did Section 936 Cause the Secular Decline? Yes.

Posted by Jack Duval

Mar 5, 2015 10:05:00 AM

This blog post continues my series on Company Town investment risks to total wealth.  I have been using Puerto Rico as an exemplar of these risks.  For an introduction to Company Town risks see this.

Section 262 and 936 Tax Incentives

The U.S. government has a long history of supporting it’s territorial possessions through tax and other development incentives.  Amongst all the territories, Puerto Rico has been the primary beneficiary of these incentives.

The first tax incentive for Puerto Rico came to be under Section 262 of the Revenue Act of 1921.[1] This incentive exempted qualified U.S. firms from taxes on all income derived from sources outside the United States. However, to qualify, the U.S. firms had to derive 80 percent or more of their gross income from operations in U.S. possessions, among other requirements.

Section 262, along with a local tax incentive in Puerto Rico called “Operation Bootstrap”, lead to a long manufacturing boom in labor-intensive industries from 1948 to 1972.[2] By 1978, that boom had faded and GNP and physical investment in Puerto Rico were in decline.

In 1976, the modern version of the Section 936 tax incentive was formed under the Tax Reform Act.[3] It was further revised in 1982 under the Tax Equity and Fiscal Responsibility Act and then again in 1986 and 1993.[4] In 1996 President Clinton repealed Section 936 and instituted a ten-year phase out that was completed in 2006.

The continuance of the Puerto Rico tax incentives in 1976 contributed significantly to Puerto Rico’s eventual recovery and economic expansion after the sluggish mid- to late-1970s period.  While it did not see a second wave of labor-intensive manufacturing gains, Puerto Rico did experience an expansion of capital-intensive manufacturing, particularly in the pharmaceutical sector.

The reliance on these tax incentives became self-evident in 2006, the year Section 936 was completely phased out.  It was this year that marked the beginning of Puerto Rico’s secular decline.

Chart 1:  Puerto Rico GDP and Section 936[5]

To download a higher resolution image, click here.

Growthand936

 

As can be seen clearly in Chart 1, above, Puerto Rico’s economic growth became highly dependent upon Section 936.  Unlike most company towns, which are created around a natural resource or location advantage, Puerto Rico became a company town based on U.S. tax policy.

This is an unsteady foundation to build an economic house upon.  U.S. tax laws change with the wind as public opinion shifts, party majorities switch, and new presidents are elected..

This company town reliance can be seen in Table 1, below, which summarizes the number of years of growth or no growth for the years when Section 936 was in force and when it was not.

Table 1:  Contingency Table of Puerto Rico GDP Growth and Section 936[6]

 

 

Growth

No Growth

Total

Section 936

28

3

31

No Section 936

7

7

14

Total

35

10

45

What was obvious in Chart 1, above, is even more starkly portrayed in the table. During the 31 years when Section 936 was in effect, the Puerto Rico economy achieved growth in 28 years, or 90.32 percent of the time.  In the 14 years when Section 936 was not in effect, Puerto Rico achieved growth in only seven years, or 50 percent of the time. 

Logistic Regression

We can also use logistic regression to see what impact Section 936 had on Puerto Rico growth. Logistic regression is a statistical technique that measures the impact of one or more categorical or continuous variables on another categorical variable.  A simple example of this is the application of medicine to a sick patient:  a categorical independent variable (did the patient receive the medicine? – yes/no); is used to explain a dependent variable (did the patient get better? – yes/no).

In this case, the “medicine received” is Section 936, and the observed response is “did the economy grow?" From the logistic regression we can calculate the odds ratio.  For our data, the odds ratio gives the change in the odds of achieving economic growth resulting from the application of the Section 936 “medicine”. In this model, the odds ratio is 8.75.[7] This means the odds of Puerto Rico achieving growth were almost nine times higher when Section 936 was in force than when it was not.

These data tell us that Puerto Rico had become a company town built upon the shifting sands of U.S. tax policy.  Indeed, the island economy had already experienced the boom and bust cycle of reliance upon U.S. tax policy going back to 1921.

Puerto Rico’s secular decline began during the expiration of the Section 936 tax incentive. As you can see here, the ensuing brutal recession affected all aspects of Puerto Rico residents total wealth.

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For information about securities expert Jack Duval, click here.

For my previous coverage of the Puerto Rico municipal bond crisis, see this.

Notes:

[1]        J. Tomas Hexner and Glenn P. Jenkins; Puerto Rico and Section 936: A Costly Dependence; 10 Tax Notes International 235; January 16, 1995; P. 237. Available at: http://www.queensjdiexec.org/publications/qed_dp_119.pdf;  Accessed January 22, 2015.

[2]        Id.

[3]        Id.

[4]        Id.

[5]        Data obtained from the World Bank and updated as of December 18, 2014. Note that World Bank data are calendar year, whereas Puerto Rico Government Development Bank data are on a July-June fiscal year.  World Bank data are converted to a 2010 base year.  World Bank data available at: http://data.worldbank.org/country/puerto-rico; Accessed February 28, 2015.

[6]        Summary statistics will be published in my forthcoming white paper.

[7]        The logistic regression model will be published in my forthcoming white paper.

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Topics: municipal bond crisis, closed-end funds, Puerto Rico, UBS, securities litigation, Company Town, Total Wealth Diversification

UBS Puerto Rico Forced Brokers to Sell Proprietary Closed-end Funds - New Evidence

Posted by Jack Duval

Feb 6, 2015 9:00:00 AM

UBS_Puerto_Rico

 

In an explosive story just out from Suzanne Barlyn of Reuters, it appears that in April 2011, a full two years before the crash of the Puerto Rico municipal bond market, UBS brokers revolted against selling the proprietary leveraged closed-end bond funds that later blew up.

Their misgivings became so great that when a group of brokers was asked by the firm why they weren’t selling more of the funds’ shares they came up with a list of 22 reasons, according to people familiar with the matter. The concerns, which the brokers said were based on their own views and feedback from clients, included allegations the funds  suffered from low liquidity, excessive leverage, oversupply and instability.  They were wary, in part, because many of the funds were loaded up with debt of the Puerto Rican government and related entities that was underwritten by UBS, the people said. (Emphasis added)

The blockbuster news is that there is an audio recording of Miguel Ferrer, the (then) chairman of UBS Financial Services Inc of Puerto Rico, imploring the disgruntaled brokers to sell the proprietary funds.  Barlyn reports that Ferrer told the brokers to "change their mindset or leave."

“You need to focus again on the attractive benefits of our funds and stop this nonsense that there are no products available – because if there are no products, go home, get a new job!” Ferrer can be heard telling them in Spanish in the recording, which was made by one of those attending.

Ferrer stressed that the brokers had almost $1 billion in cash in their clients’ accounts that was not generating commissions. He said the team’s production had dropped  “40-something-percent” (a figure now disputed by UBS that says it was closer to 10 percent), that “overall we are doing quite badly”  and it was “bullshit” for brokers to claim there weren’t products to sell. (Emphasis added)

It would appear that Ferrer's exhortations were heeded as more and more of the UBS closed-end municipal bond funds were sold leading up to the crisis in 2013.

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Jack Duval is a leading expert on Puerto Rico municipal bonds and UBS closed-end funds.  For more information about Jack, click here.

For my previous coverage of the Puerto Rico municipal bond crisis, see this.

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Topics: municipal bond crisis, closed-end funds, Puerto Rico, UBS, securities litigation

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