Puerto Rico Municipal Bonds

The securities attorneys with Shepherd Smith Edwards & Kantas are investigating claims of investors who purchased Puerto Rico municipal bonds. Many of the largest brokerage firms that operate in Puerto Rico, including UBS, Banco Popular, and Banco Santander, have been selling huge amounts of securities which directly or indirectly were supposed to be investments in Puerto Rico municipal bonds. Those bonds have been viewed as attractive investments by many investors for years as a result of their tax incentives and relatively high yield.

Interest paid by municipal bonds issued by Puerto Rico is exempt from taxation of any type in the United States. This is a significant incentive over municipal bonds issued by United States government entities, which are typically only exempt from Federal income tax, and would still be considered income by state and/or local income taxes. (The exception for the State and local taxes is that most states exempt their own issuances from income taxes, but tax municipal bonds issued by other states.) Additionally, municipal bonds issued by Puerto Rico have, for years, carried relatively high-interest rates. Those high rates, coupled with the preferential tax treatments, have made it easy for brokers to convince their clients, particularly in Puerto Rico, to invest heavily in these securities.

However, even as early as 2009 there were strong indications, as well as publicly available information, that these bonds were in trouble. In 2009, Puerto Rico’s governor declared a state of fiscal emergency. At the time, the territory carried approximately $47 billion in debt and was already bordering on junk-bond/high-risk credit ratings. Yet at the same time, Puerto Rico’s economy shrank by roughly 5.5% in the same year, marking huge challenges for Puerto Rico’s ability to support such a level of debt.

By 2012, the situation was even more dire. Articles were clearly warning potential investors about the huge risks that Puerto Rico municipal bond investments carried. These articles explained that Puerto Rico was having to continually issue new bonds to support itself. At the same time, it had a per capita income of just over $15,000, which was less than half of the poorest state in the U.S. It had an unemployment rate of 15.5%, 45% of the population was living below the poverty line, and 20% of all personal income was from public support, either from the Federal government or the Puerto Rican government. All of these factors show a commonwealth which had a very weak economy, and therefore a very weak tax base.

Puerto Rico was still carrying a budget shortfall, to the tune of almost $1 billion annually. The only way the government was still operating was by issuing new bonds and by selling off public assets, such as the main airport to the island and major toll road highways. But these sources of income only go so far; there are only so many public assets to sell.

Yet, despite these weaknesses, brokerage firms continued to push these bonds heavily, despite the fact many of the bonds carried maturities of 30 years or more. That kind of maturity significantly increases the risk that the bond will default before the investor gets his money back.

Puerto Rico’s economy has continued to struggle this year, resulting in huge losses in Puerto Rican municipal bonds. In the first six months of 2013 alone, Puerto Rico’s economy shrunk another 5%. As a result, bond values were down over 17% this year alone. Moreover, any investors who have been holding out hope that the situation would get bailed out by the U.S. Federal Government have had those hopes dashed. Not only is the U.S. Government shut down over its own financial turmoil, but the U.S. Treasury Department has unofficially stated that there is no plan to provide assistance to Puerto Rico.

So for the investors who are currently holding the bag, the question becomes, how did this happen? How did so many individual investors end up with huge losses in what was supposed to be low-risk investments?

UBS is the largest and most prevalent brokerage firm operating in Puerto Rico, in terms of assets under management and number of brokers living and working on the island. According to a number of complaints recently filed, UBS brokers were consistently recommending that their clients invest huge portions of their accounts in proprietary UBS products which were supposed to invest almost exclusively in Puerto Rico municipal bonds. This, in of itself, is a risky proposition. Not only do these specific bonds carry very high risks, as was explained in detail above, but the timing of it substantially increased the risks.

Bond values have an inverse relationship with interest rates. That means that if you have a bond worth $1,000 and interest rates go up, the value of that bond will go down, to say $900. Conversely, if interest rates go down, the price to buy that bond on the market will go up, for example to $1,100. From 2009 through early 2013, interest rates have been at historic lows. That means that bond prices were effectively as high as they could realistically go. So people that were buying bonds, particularly municipal bonds, during that time were buying securities which could only really go one direction; down. Now, there is certainly a question of when the price would go down. There is no way to know exactly when interest rates would start to rise again as they did around June of this year. But inevitably it would happen, and the value of any bonds investors owned at that point would drop.

For some bond buyers, that risk isn’t a huge concern. If an investor bought a bond in 2010 that matured in 2015 and interest rates rose substantially during that time, the investor could just hold onto the bond until it matured in 2015 and get all of his principal back, assuming the issuer didn’t default. Unlike stocks, bonds have a fixed maturity where the investor is supposed to get 100% of his principal back. However, as was mentioned above, most of these Puerto Rico municipal bonds being sold carrier 30 year or more maturities, meaning that in order to take advantage of that guaranteed return of principal, the investor could be forced to sit on a bond for the entire 30 years, missing out on potentially significantly greater returns elsewhere. Even then, that assumes that Puerto Rico wouldn’t be forced to default on that bond sometime during those 30 years. There is no indication that the U.S. government is going to pay for it if Puerto Rico can’t.

This situation, even if this was all that had happened, would be bad enough for investors. However, here it is just the tip of the iceberg. Most, if not all, of the proprietary funds that brokers with UBS and other brokerage firms in Puerto Rico were selling, were heavily leveraged. Many of those funds, which specifically invested almost exclusively in Puerto Rico municipal bonds, were leveraged up to or slightly over 50%. That means that for every dollar invested in the fund by an actual investor, the fund was borrowing another dollar to invest alongside it. Funds do that in an effort to boost returns. However, increased upside potential comes with increased potential losses. When these funds are so heavily leveraged, a fall of 17% in the value of the underlying securities, like what Puerto Rico municipal bonds have done in 2013 alone, will result in approximately a loss of 34% for investors in these leveraged funds. Moreover, similar municipal bond funds based out of the continental United States are not even permitted to leverage that much; the leverage taken on by UBS Puerto Rico funds are roughly double what they would have been permitted to do in the U.S.

To make matters even worse, numerous UBS brokers have been accused of encouraging their clients to buy more and more of these municipal bonds and municipal bond funds by taking out lines of credit, either by taking out a home equity loan or other more traditional loan, or by borrowing money directly from UBS through a margin account. Every level of leverage increases the risk the investor is carrying by orders of magnitude. When an investor takes out a home equity loan to invest, for example, not only does the investor now have to make interest payments to his bank for the amount of the outstanding loan, but if the investors’ investment fails, the investor’s home is now on the line. Many investors who take out a home equity loan to invest ultimately end up losing the home.

A margin account can cause just as significant of problems. When an investor uses a margin account and borrows extra money from his brokerage firm to invest, he is going to have to pay an annual interest rate on the amount borrowed for as long as it is outstanding. That means that his investment has to get a return greater than the rate the firm is charging him to get any return at all. Moreover, brokerage firms have very strict guidelines on equity ratios in the account. The brokerage firm will require there to be an amount of assets in the account a certain amount greater than the amount that it loaned the investor. For example, a firm might loan an investor $100,000 in a margin account, but only so long as the number of funds and/or securities in the account was at least twice the amount of money loaned, or $200,000. If the securities in the account fall in value, however, the firm will automatically sell off securities in the account and use those funds to pay itself back until the ratio gets back to what the firm requires.

This can result in a very rapid downward spiral effect for a customer account. A drop of account value of even 10% can result in margin calls, but the more funds the firm forces into the market, the more the value of the other similar securities can fall, causing further margin calls. A relatively modest drop, that in a non-margin account could be easily recovered, can completely wipe out a margin account under some circumstances. And this is precisely what brokers for UBS and potentially other brokerage firms in Puerto Rico have been accused of doing: encouraging their clients to borrow as much money as possible, through one of these means, in order to push ever greater amounts of money into these municipal bond funds, despite having full knowledge of the incredibly speculative nature of these investment strategies.

All told, it appears that roughly $10 billion worth of Puerto Rico municipal bonds were sold to investors in this manner. It is unclear exactly what that number will be worth when the dust clears, but the losses at this point are already catastrophic, and there is no evidence that it is going to slow down anytime soon. If you have invested in Puerto Rico bonds at the recommendation of your broker, contact the lawyers with Shepherd Smith Edwards & Kantas for a free consultation and evaluation of your account to determine if you might have a claim to attempt to recover some or all of your losses.

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