Monday, October 24, 2016

UBS Puerto Rico’s COFINA Conflicts Were Even Worse Than ERS Conflicts

By Craig McCann, PhD, CFA, Edward O'Neal, PhD, CVA and Susan Song, MF

We have written extensively about the wreckage caused by UBS’s business model in Puerto Rico. See “UBS Puerto Rico’s Bond Fund Debacle: What We Know so Far” available in English here and available in Spanish, “Lo que Sabemos hasta Ahora de la Debacle de los Fondos de Bonos UBS Puerto Rico,” here. All our Puerto Rico posts are available in English here and in Spanish here.

UBS’s Farm-to-Table business model included encouraging the Employee Retirement System (“ERS”) and other entities in Puerto Rico to issue bonds when no viable market except for UBS’s leveraged closed end funds existed on the Island, on the mainland or globally. UBS’s control of $9 billion of portfolio holdings in leveraged closed end funds it had already sold into its retail customers’ accounts allowed UBS to unload newly issued bonds and reap substantial underwritings fees. UBS’s conflicted underwritings and the investor harm which predictably followed never would have occurred if the funds had been registered under the 1940 Investment Company Act or if UBS Financial Services of Puerto Rico (“UBS PR”) had not disregarded its most basic duty of loyalty.

We illustrated the dramatic change in UBS’s closed end funds’ holdings in 2008 as UBS served as the lead underwriter on the ERS Pension Funding Bonds in 2008 in “UBS Succumbed to Conflicts and Purchased $1.7 Billion of Employee Retirement System Bonds into its Puerto Rican Municipal bond Funds in 2008” available in English here and in Spanish here.

UBS Puerto Rico’s Underwriting of COFINA 2008A Bonds Was Shocking

UBS Financial Services of Puerto Rico was the sole underwriter for the $737 million COFINA 2008A bond offering, dated June 25, 2008. See Figure 1. The Official Statement is available here.

Figure 1:COFINA 2008A, Official Statement, June 25, 2008, page 1

The COFINA 2008A bonds included $248.2 million from 10 zero coupon bonds with maturities ranging from 2024 to 2036 and $488.8 million from 6 coupon bonds with maturities ranging from 2027 to 2038. See Figure 2.

Figure 2: COFINA 2008A, Official Statement, June 25, 2008, page 2
The COFINA 2008A bond deal provides a clearer indication of UBS Puerto Rico’s conflicted conduct than the three 2008 ERS underwritings because UBS PR was the sole underwriter of the COFINA 2008A offering. In Figure 3, we report the shocking fact that UBS bought 100% of this $737 million offering into the UBS PR closed end funds. There was literally no market for these UBS bonds other than the portfolios controlled by UBS PR, held in retail accounts at UBS PR.

Figure 3: UBS Puerto Rico Funds Held 99.6% of COFINA 2008 Series A Bonds

UBS Turned the Tax Free Puerto Rico Target Maturity Fund into a Superfund Site

We illustrate the impact on the UBS Funds’ holdings with the Tax Free Puerto Rico Target Maturity Fund (“TFPRTMF”). In Figure 4, we excerpt the holdings of the TFPRTMF from the Fund’s July 31, 2008 Annual Report. These holdings are the first reported after the COFINA 2008A issue date. Notice that virtually 100% of the 2008A 6.13% coupon bonds maturing 2027, 2028, 2029 and 2030 were bought into this fund.

Figure 4: UBS Tax Free Puerto Rico Target Maturity Fund Holdings, Annual Report, July 31, 2008

Worse than that, the TFPRTMF had no COFINA bonds until the 2007B offering UBS also underwrote and then held $275 million of the 2008A issue and $20 million from the 2007B offering in its $566 million portfolio. Thus, in just 12 months UBS converted this fund from 0% to over 100% of the net asset value invested in COFINA bonds, solely because UBS needed a place to put the unmarketable bonds it was underwriting. See Figure 5.

Figure 5: TFPRTMF Net Assets Quickly Become More Than 100% COFINA Bonds

UBS Financial Services of Puerto Rico was the lead underwriter for the $1.333 billion COFINA 2007B bond offering, dated July 17, 2007. See Figure 6. The Official Statement is available here.

Figure 6: COFINA 2007B, Official Statement, July 17, 2007, page 1

The COFINA 2007B bonds included $147.1 million from 6 zero coupon bonds with maturities
ranging from 2027 to 2032 and $1.186 billion from 9 coupon bonds with maturities ranging from 2036 to 2057. See Figure 7.

Figure 7: COFINA 2007B, Official Statement, July 17, 2007, page 2
The COFINA 2007B bonds listed in Figure 7 add another wrinkle. These zero-coupon bonds maturing in 2029 and 2030 do not belong in any fund sold to investors with investment objectives of high income consistent with capital preservation. Figure 8 excerpts the Fund’s Investment Objectives from the same 2008 Annual Report. Figure 9 excerpts similar language from the Funds 2nd Quarter 2013 Quarterly Review.

Figure 8: UBS Tax Free Puerto Rico Target Maturity Fund Investment Objectives, Annual Report, July 31, 2008

Figure 9: UBS Tax Free Puerto Rico Target Maturity Fund Investment Objectives, Quarterly Review, June 30, 2013

Now, returning to Figure 3, the UBS Funds not only bought 100% of the coupon bonds but also 100% of the $248 million long-term zero-coupon bonds in the COFINA 2008A offering. Again, these bonds don’t belong in any fund whose investment objective is high current income consistent with capital preservation. These zero-coupon bonds were nearly 20% of the Tax Free Puerto Rico Target Maturity Fund’s net assets but provided no income and exposed investors to the credit risk, interest rate risk and liquidity risk of 30- and 40-year coupon bonds.

Summing up

UBS Puerto Rico earned billions of dollars in Puerto Rico by underwriting and trading leveraged closed end municipal bond funds and paying retail prices for conflicted bonds it was underwriting. We’ve illustrated some of UBS’s conflicts in the past with the 2008A, B and C ERS offerings on which UBS served as lead underwriter. Because we can’t know exactly how much of the ERS offerings UBS took, we can’t prove all of its allocation went into the UBS PR Funds. The COFINA 2008A offering on the other hand adds clarity to an assessment of UBS PR’s conduct. UBS PR underwrote 100% of this $737 million issue and bought 100% of it into the UBS Funds even though the bonds were antithetical to the Funds’ stated investment objectives.

Wednesday, October 5, 2016

Padilla et al v Royal Alliance - $1.1 million non-traded REIT, Annuity Award

In October 2016, a FINRA arbitration panel in San Francisco, CA ordered Royal Alliance Associates to pay $1,105,000 in compensatory. You can read the award here. Dr. McCann testified on liability and damages over Royal Alliance's sale of non-traded REITs (Inland American REIT, Inland Western REIT and Dividend Capital Diversified Realty Trust) and variable annuities to the Claimants for their retirement portfolios.

Dr. McCann's "Fiduciary Duties and Non-traded REITs" can be downloaded here and SLCG's blog posts on non-traded REITs can be found here.

Wednesday, September 28, 2016

This is why UBS paid the SEC $15 Million over Reverse Convertible Structured Products

By Craig McCann, PhD, CFA and Mike Yan, PhD, CFA, FRM

The Securities and Exchange Commission today announced a $15 million settlement with UBS over structured products linked to high volatility stocks today. The SEC press release announcing the settlement is available here and its Order Instituting Proceedings is available here. This post explains the underlying notes and why UBS may have paid the SEC a substantial settlement over sales practices related to UBS’s reverse convertible notes (“RCNs”).

UBS sold thousands of structured notes to retail investors in recent years. Some of those notes, the RCNs, pay a higher coupon than traditional notes but expose investors to the downside risk in single stocks. When an investor buys a reverse convertible note they are selling a put option on the underlying asset and paying the purchase price of the note to fully collateralize the investor’s obligation to pay the issuer if the short put option is in the money at maturity. The RCN coupon is partly interest on the collateral the investor posts and partly compensation for the short put option which exposes investors to the underlying asset’s downside risk.

UBS has a significant information advantage over retail investors and therefore the risk investors take on when purchasing an RCN from UBS might be significantly higher than they expect and the high coupon they receive not high enough to compensate them for the downside risk. We have published several peer-reviewed papers on the structured notes and posted on over twenty thousand research report on the retail structured products.

We searched 424B2 filings on SEC’s EDGAR for RCNs linked to a single stock issued in 2011 and 2012 and found that UBS Financial Services was the Placement Agent for 1,152 RCNs listed in Table 1, which means UBS Financial Services purchased those RCNs from the issuer in the offering and sold the notes to its clients. The issuers of those RCNs include Barclays, Deutsche Bank, HSBC, JP Morgan, Morgan Stanley, Royal Bank of Canada, and UBS.

Table 1: Reverse Convertible Notes Sold by UBS Financial Services in 2011 and 2012

A. RCN Description

A single observation reverse convertible note (“SO RCN”) can be valued as a combination of a note from the issuer, a short European out-of-the-money cash-or-nothing binary put option, and a short European out-of-the-money put option on the underlying stock.

Figure 1: The Final Payoff of the SO RCNs.
For example, UBS trigger yield optimization notes linked to the common stock of Halliburton Company issued in January 2011 is a single observation reverse convertible.1 The 1-year notes pay monthly coupon at an annualized rate of 10.53%. At maturity, the notes pay the market value of one share of Halliburton Company’s common stock if the stock price falls below 80% of the initial level at the final observation date. In this case, the investors suffer a loss of more than 20%. Otherwise, the notes pay back the principal.

___________________________________ See also SLCG report on

The Halliburton-linked structured product payoff is the same as receiving the $39.23 face value of the note less $7.85 if the stock closes below $31.38 on the valuation date (this is the payoff to 7.85 short cash-or-nothing put options with a strike price of $31.38), less the amount if any Halliburton closes below $31.38 (this is the payoff to a short put option with a strike price of $31.38).

An airbag single observation reverse convertible note (“Airbag RCN”) can be valued as a combination of a note from the issuer, and some short European out-of-the-money put options on the underlying stock. The number of the options equals the ratio of the current underlying price and the strike price of the put option. For example, if the strike price is 80% of the initial index level, then the ratio 1.25 is the share number of the put option.

Figure 2: The final payoff of the airbag single observation reverse convertible
UBS airbag trigger yield optimization notes linked to Apple Inc. issued in April 2012 is an example of the airbag single observation reverse convertible. The 6-month notes pay monthly coupon at an annualized rate of 7.91%. The maturity payoff of the principal is reduced by the product of 1/0.85 and the losses of the Apple stock beyond the 15% buffer. Otherwise, the notes pay back the full principal.


An autocallable reverse convertible note (“Autocallable RCN”) can have maturity payoffs which look like either Figure 1 or Figure 2, paying the face value if the underlying doesn’t close below a trigger price. In addition, autocallable RCNs have a call feature allowing the issuer to refund the entire principal early at pre-determined call dates, if the underlying price exceeds the initial level on the call date. Once the notes pre-pays its principal, no further coupons or principal payments will be made.

B. Selection of Stocks with High Implied Volatility

Once the structure of a reverse convertible – single observation, airbag, autocallable – and the term, trigger and coupon are specified the note’s fair market value depends on the volatility of the underlying stock. The more volatile the stock, the more likely the stock price is to be below the trigger resulting in losses to the investor. Holding constant the other attributes of the RCN, UBS could benefit at the expense of its retail clients by selecting higher volatility stocks.

In fact, we find that UBS selects underlying stocks for its RCNs with unusually high volatilities. 73% of the stocks underlying UBS’s RCNs were in the S&P 500. 16% are from the additional 2,500 stocks in the Russell 3000 but not in the S&P 500. The remaining underlying stocks appear to be mostly stocks issued by large foreign issuers that would be in the S&P 500 if they were US stocks.

Of the underlying stocks chosen by UBS that were in the S&P 500, 83.7% were in the top half of the distribution of implied volatilities within the S&P 500 when the RCNs were issued. This number increases to 95.6% when we include the underlying that are outside of the S&P 500. This is extremely strong evidence that UBS was selecting unusually volatile stocks from the pool of stocks and that this harmed investors.

Figure 3 is a histogram of the market value of UBS’s RCNs issued in 2011 and 2012 sorted by the distribution of volatilities in the S&P 500 at the time UBS issued the notes. If UBS was not purposely selecting underlying stocks with high volatilities, the histogram would be flat with each vertical bar representing 10% of the market capitalization of the RCNs issued. Instead the distribution is skewed sharply towards the higher volatilities found in S&P 500 stocks.

Figure 3: Most of UBS’s RCNs Linked to S&P 500 Stocks, Mostly More Volatile

C. What the Implied Volatility Tells You

The information of the implied volatility is useful for investors. When the investors purchased RCNs, what matters is the uncertainty surrounding the future value of the underlying stock. The best estimate of this uncertainty is likely to be the volatility implied by option prices although it could be the consensus volatility forecasts of dealers (they should be the same). In any case, that there is some variation in dealers’ forecasts is irrelevant to determining the best estimate of future volatility.

Although the implied volatilities historically overestimate realized volatility, this difference between implied volatilities and realized volatility seems to be related to the non-normality of returns and compensation for volatility risk. Both are equally of concern to purchasers of reverse convertibles as they are to direct sellers of options. Thus, that implied volatilities overestimate realized volatility doesn’t make them inappropriate for valuing reverse convertibles or assessing the risk of losses upon conversion to stock payoffs.

Knowing the term, underlying stock and threshold of the reverse convertible is insufficient for an investor to develop an opinion of the likelihood that the reverse convertible will convert into the underlying stock. For instance - and directly on point – investors might believe that the underlying stock is about as volatile as the S&P 500 or the Dow Jones Industrial Average levels commonly reported each day. Because this belief would be mistaken, it would cause investors to underestimate the likelihood of the note converting into stock at maturity and overestimate the value of the reverse convertible note.

The only way for investors to develop a good estimate of this likelihood on the issue date is for the investor to know the implied volatility of the stock. The implied volatilities of the S&P 500 stocks which underlie 73% of UBS’s reverse convertible issuances were nearly double the contemporaneous S&P 500 implied volatility; reverse convertible investors who intuit the risk of converting to stock by thinking about the volatility of the S&P 500 will be significantly mistaken.

Tuesday, September 13, 2016

Craig McCann’s Comment Letter in Support of NASAA’s REIT Guidelines

Yesterday, Craig McCann, President of SLCG, submitted a comment letter in support of NASAA’s proposed concentration limit for nontraded REITs. He also urged NASAA to find a mechanism for ensuring roll-up and advisory contract protections promised by Sponsors to investors as a condition for receiving registration permission are not summarily eliminated when capital raises end and investors truly need these protections. Dr. McCann’s comment letter is available here.