Friday, October 30, 2015

UBS Puerto Rico Still Can’t Shoot Straight

By Craig McCann, PhD and Susan Song

We’ve written extensively about the investment carnage caused by UBS Puerto Rico’s management and sales of closed end municipal bonds funds. A summary of our findings can be found here: UBS Puerto Rico’s Bond Fund Debacle: What We Know So Far .

Others will have to decide whether UBS was just incompetent or also wolfishly indifferent to Puerto Rico investors but recent evidence demonstrates that UBS Asset Managers of Puerto Rico continues to be, at least, incompetent.

The fourteen closed end funds listed in Figure 1 were solely managed by UBS Asset Managers of Puerto Rico.

Figure 1. Closed End Funds Solely Managed by UBS Asset Managers of Puerto Rico
The nine closed end funds listed in Figure 2 were co-managed with Popular Asset Management.

Figure 2. Closed End Funds Co-Managed with Popular Asset Management
Each quarter, UBS prepares and posts to its website a Quarterly Review reporting performance information for each of the 23 funds. The Quarterly Reviews for 4th quarter 2014 are available here , for 1st quarter 2015 here and 2nd quarter 2015 here. Figure 3 is the cover page for the first quarter of 2015.

Figure 3. First Quarter 2015 Quarterly Review Cover Page
Compare the data in the Quarterly Review for the UBS Puerto Rico Fixed Income Fund VI for the 1st quarter 2015 in Figure 4a with the data in the Quarterly Review for the 4th quarter 2014 in Figure 4b.

Figure 4a. First Quarter 2015 Quarterly Review UBS PR Fixed Income Fund VI (page 44 of 115 in 1Q2015 pdf.)

Figure 4b. Fourth Quarter 2014 Quarterly Review UBS PR Fixed Income Fund VI (page 44 of 115 in 4Q2014 pdf.)
The “Pricing and Distribution History”, “Portfolio Statistics and Characteristics” and “Portfolio Holdings” sections are updated at the end of the 1st quarter 2015 but the “Portfolio Summary”, “Credit Quality”, “Average Annual Total Return” and “Growth of a $10,000 investment as of …” are not updated. That is, the 1st quarter 2015 data in these sections of the Quarterly Review are December 31, 2014 values, not March 31, 2015 values.

The problem is with UBS Asset Managers of Puerto Rico since only the 14 funds solely managed by UBS Asset Managers of Puerto Rico listed in Figure 1 have these incorrect Quarterly Reviews.

Compare the data in the Quarterly Reviews for the UBS Puerto Rico Investors Tax Free Fund IV - one of the nine funds co-managed by Popular listed in Figure 2 - for the 1st quarter 2015 in Figure 5a with the data for the 4th quarter 2014 in Figure 5b. For this Popular fund, the 1st quarter 2015 data in all sections of the review are March 31, 2015 values not December 31, 2014 values.

Figure 5a. First Quarter 2015 Quarterly Review Puerto Rico Investors Tax-Free Fund IV (page 74 of 115 in 1Q2015 pdf.)
Figure 5b. Fourth Quarter 2014 Quarterly Review Puerto Rico Investors Tax-Free Fund IV (page 74 of 115 in 4Q2014 pdf.)

Tuesday, October 13, 2015

More Signs of Trouble for Auto Liquidators

By Craig McCann, PhD and Mike Yan, PhD

In “The Recent Market Turmoil Spells Trouble for Auto Liquidators Like Interactive Brokers” we wrote about how the market decline on August 24, 2015 revealed continuing problems at auto-liquidating brokerage firms that cater to active traders. These active traders’ accounts typically are subject to “portfolio margin” requirements which we have written about at length. 1

We showed that thinly traded long-dated, deep out-of-the money SPX put options were bought on August 24, 2015 at implausibly high prices, purportedly to cure margin deficiencies. We showed the price of one SPX put option increased from $4 to as high as $83 in seconds as a result of auto-liquidation transactions after which the option price quickly dropped back to around $4. These auto-liquidation trades converted an account from a credit balance to a debit balance in seconds when a rational liquidation would have cured the margin deficiency and left the account equity intact.

In this blog post we explain how rational liquidations would have saved an auto-liquidated account using another stylized example from an account that was liquidated to a debit balance during the morning of August 24, 2015. Far from our prior example, we use prices of near expiration, at-the-money call options on Barclay’s VXX ETN linked to the VIX index with different strikes to demonstrate the harm caused by auto-liquidations that occurred while an investor was froze out of making trades in nearby options.

Call Options

American-style call options give the holder the right to buy an asset at a fixed price on or before some future date. For example, a call option on the VXX expiring August 28, 2015 with a strike price of $24 gave investors the right to buy the VXX for $24 per note on or before August 28, 2015.

If the VXX is worth more than $24 when the options expired, the investor would receive the difference between the VXX price and the option’s $24 strike price. If the VXX was worth less than the $24 strike price at expiration, the option would expire worthless.

For the same underlying asset (VXX in our example) and the same expiration date (August 28, 2015 in our example), options with lower strike prices are worth more than options with higher strike prices. To see why this must be true, consider Table 1 and Figure 1.

Table 1: Option Payoffs by Strike Price and Expiration

The $23 strike price pays the same as the higher strike price options when they all pay nothing and pays strictly more than the higher strike price options when they pay anything at all. Thus, the $23 strike price option has to be worth more than the $24 and $25 strike price options.

1“Optimizing Portfolio Liquidation Under Risk-Based Margin Requirements” with Geng Deng and Tim Dulaney, Journal of Finance and Investment Analysis, vol. 2, no. 1, 2013, 121-153

    1.   If VXX closes less than $23, all three options expire worthless.

    2.   If VXX closes greater than $23 but less than $24, the $23 strike price option pays something less than $1 and the other two options pay nothing.

    3.   If VXX closes above $24 but less than or equal to $25, the $23 strike price option pays between $1 and $2, the $24 strike price option pays $1 less and the $25 strike option pays nothing.

    4.   If VXX closes above $25, the $23 strike price option pays more than $2, the $24 strike price option again pays $1 less than the $23 strike price option and the $25 strike option pays $2 less than the $23 strike price option.

Figure 1 Lower Strike Price Call Options Payoff More at Maturity

More generally, if two otherwise identical deep in-the-money call options are about to expire, the difference in the option prices will be approximately equal to the difference in strike prices. The lower strike price option will pay the difference in the two options’ strike prices more than the higher strike price option in the likely event that both options are still in-the-money at the impending expiration.

If the options are not deep in-the-money and near expiration, the difference in option prices will be less than the difference in strike prices but the lower strike price call options will still be worth more than the higher strike price call options since the lower strike price call options always pay off at least as much as the higher strike price options and sometimes they pay more. This is the pattern we observe in Figure 2 below.

Implausible Option Prices on August 24, 2015
    August 21, 2014
On Friday, August 21, 2015 VXX increased during the day from $18 to $21. Following a nearly identical pattern, the at-the-money call options on VXX increased throughout the day with the lower strike price options trading at higher prices than the higher strike price options. See Figure 2.

Figure 2: VXX and VXX Call Options Expiring August 28, 2015, August 21, 2015

The differences in option prices illustrated in Figure 2 follow the pattern we expect. Lower strike price options, other things equal, have higher prices. If this pattern doesn’t hold there is an arbitrage opportunity; an investor could buy the low strike price option, sell the high strike price option pocketing the difference in prices and be certain the get an additional non-negative cash flow when the options expire. Such arbitrage opportunities can’t last long in actively traded markets. The differences in option prices are roughly the difference between strike prices multiplied by the likelihood that VXX would increase over the next week and the options would end up in-the-money. The difference in prices approaches the difference in strike prices as we consider pairs of adjacent call options with lower and lower strike prices. See Table 2.

Table 2: Average August 28, 2015 Expiration VXX Option Prices, August 21, 2015

    August 24, 2014
On Monday August 24, 2015 VXX traded between $21 and $29 and the option prices we plotted in Figure 2 all increase substantially. We observe some prices on higher strike price options which had been deep out-of-the-money on August 21, 2015 but became at-the-money on August 24, 2015 being distorted by apparent auto-liquidations. Except for during auto-liquidations in the morning, the price of these options with strike prices from $24 to $27 increased up and down through the day Monday closely paralleling the VXX stock price. See Figure 3.

Figure 3: August 28, 2015 Expiration VXX Call Options Prices, August 24, 2015

Table 3a and 3b report the average option price during the 3-minute periods starting at 9:59am and 10:18am on Monday, August 24, 2015. As illustrated in Figure 3, there were periods in the morning on August 24, 2015 when the VXX call option prices did not decrease with strike prices as they must as a matter of logic, as they had on Friday, August 21, 2015 and as they did again later in the day on August 24, 2015.

Table 3a: August 28, 2015 Expiration VXX Option Prices, Monday, August 24, 2015 9:59 am

Table 3b: August 28, 2015 Expiration VXX Option Prices, Monday, August 24, 2015 10:18 pm

Table 3c: August 28, 2015 Expiration VXX Option Prices, Monday, August 24, 2015 Total Trading Volume

Figure 4 highlights the VXX call option prices during the morning on August 24, 2015.

Figure 4: August 28, 2015 Expiration VXX Call Options Prices, August 24, 2015 AM

The prices of these options – especially the $25.5, $26 and $26.5 strike price options - deviated significantly from plausible prices. These anomalies appear to be caused by the price impact of auto-liquidators indiscriminately buying options to cover short positions without regard for the price of nearby options. No options professional would cover a short position to cure a margin deficit in this manner.

Auto-liquidating Firms Exacerbated Harm by Locking Customers Out of Their Accounts

Consider an active trader who finds herself in a margin deficit and who is short 200 VXX contracts with a $26 strike price expiring in four days. Imagine that the current market price of the $26 strike price option is $5 and the current market price of $25 strike price options is only $4.50. This pattern of prices is an arbitrage opportunity if a market professional (maybe an affiliate of the auto-liquidating brokerage firm?) can act quickly enough, buying the $25 strike price options and selling the $26 strike price options, before the distorting price impact of the auto-liquidations dissipates. Fairly quickly the price of the $26 options will fall and the price of the $25 options will increase enough so that the price of the $25 options is once again greater than the price of the $26 options.

Active traders have complained that Interactive Brokers locked them out of their accounts, forcing them to watch as their accounts were liquidated to a debit balance while trades that would have saved the accounts were available. These investors are describing exactly this type of situation. Even though the investor is short 200 VXX call options with the $26 strike price, the $25 strike price options are cheaper and would provide more margin relief per option contract. In our example, it would be much cheaper to cure the margin deficit by buying $25 strike price options rather than the $26 strike price options the trader was short. An active trader still able to trade her account would likely see this and efficiently cure the margin deficit by buying the $25 options. Once the brokerage firms start auto-liquidating an account to meet a margin call, investor-initiated account saving strategies are effectively prohibited.

Friday, October 9, 2015

Pension Purchase Agreements; The worst “investment” in the world?

By Brian Henderson PhD, CFA and Craig McCann PhD, CFA

In recent years, platforms for buying and selling pension benefit payments have been created and gained traction. Voyager Financial Group (VFG) operated one of the largest and most active exchanges for buying and selling pension payments. There is limited information available on the size of this market because these firms have operated under the radar of securities regulators.

In pension benefit agreements, a pensioner agrees to turn over a specific number of their future pension benefit payments to an investor in exchange for an upfront lump-sum payment. Typically the seller and buyer do not meet, although some limited information about the seller is disclosed to the buyer. Keeping the seller and buyer segregated means the two parties do not know the compensation to, and therefore the incentives of, the intermediaries. This means the seller does not know the price paid by the buyer, and the buyer does not know the price received by the seller. Why do the two prices differ? Because a series of intermediaries gleans hefty commissions and fees for making the arrangement.

Increased Regulatory Scrutiny

Pension purchase agreements have drawn increased scrutiny in recent years as securities regulators catch onto these schemes. Several states, including California (available here), Arkansas (available here), and New Mexico (available here) have issued orders preventing the sale of pension benefits. New York State, at the direction of Governor Cuomo, has initiated an investigation into these activities (story available here).

The U.S. Securities and Exchange Commission (available here) and FINRA (available here) have released bulletins and investor alerts highlighting the important factors to consider prior to participating in the sale or purchase of pension payments.

Perversely, the increased attention and scrutiny on pension purchase agreements in the popular press has likely exacerbated the losses to investors. The press coverage has helped inform pensioners that the contracts are often unenforceable, which has given many the idea to cease forwarding their checks or divert their pension payments back to their own accounts.

Failure to Disclose High Fees and Conflicts of Interest

According to the Arkansas Consent Order, VFG pocketed nearly 20% of the investor’s capital ($6.7 million from $34.2 million proceeds). In addition to VFG’s take, they paid commissions to other distribution agents. It appears the investor’s financial advisor was typically paid a commission of approximately 7% of the price paid by the investor, which is itself large relative to the typical commissions on mutual funds or exchange-traded funds.

The fees and commissions are typically not disclosed in pension purchase agreements. The pension benefits seller does not know the price paid by the buyer. The commissions, plus other profits to distribution agents, come from the difference between the investor’s purchase price and the amount paid to the pensioner. These high costs are undisclosed to the buyer and seller. Also undisclosed in these deals are the conflicts of interest and interests of affiliated parties.

Beyond the High Fees, Pension Investments are Unsecured Claims

What motivates the buyers and sellers to enter into these agreements? The pensioner may be willing to exchange a number of their pension payments for the immediate lump-sum if they have an unexpected expenditure such as medical bills or to purchase other investments.

Pension investors are attracted to the seemingly secure payments that they expect to receive regularly over time. For example, an investor may pay approximately $100,000 to purchase 10 years of $1,160 monthly payments, cumulating to approximately $139,000 in payments. Unfortunately for many investors, they receive only the first two years of payments after the pensioner took steps to divert the pension payments to another account.

Often, the pensioner ceases to surrender their pension payments soon after receiving the investor’s lump-sum payment. Diversion of the payments may be accomplished by simply failing to forward the checks they receive or by redirecting the funds to another account. In many cases the agreements are legally unenforceable and they are left to suffer large losses. For example, by law U.S. military pension and disability payments are non-transferrable, rendering these agreements unenforceable. The majority of contracts that SLCG has analyzed entail an investor purchasing the U.S. military retirement pension payments of a former service member. Not surprisingly, all of those payments ceased within a year or two of the agreement, leaving investors without the stable income streams they expected.

The critical flaw in pension purchase agreements is that the investor does not acquire the underlying asset, they only acquire a tenuous, unsecured claim on the cash flows. In fact, the pension payments are made to an escrow account opened in the pensioner’s name, over which they assign control rights to a trustee. The Achilles heel in the structure is that the pensioner has the ability to divert the payment away from the escrow account. As time passes, the seller’s willingness to continue forwarding the checks diminishes as the lump-sum payment amount upfront has likely been used for other purposes. It is not surprising that so many sellers simply stop forwarding their payments.

On the surface, a secondary market for structured payments may appear to improve allocative efficiency by providing an opportunity for pensioners to capitalize their payments while providing other investors who seek yield opportunities an opportunity to purchase annuity payments.

In reality, this is an opaque market where unregistered intermediaries have operated below regulators’ radar. The firms facilitating these transactions circumvent regulatory oversight by falsely claiming the pension contracts are not investments.


Pension purchase agreements are simple fraud. They present unsophisticated investors with stable, dependable cash flows but investors invariably suffer large losses as the underlying circumstances which led the pensioner to sell their future pension payments cause them to stop forwarding the pension checks.

Unfortunately, the critical flaws in the agreements’ design, and that are insurmountable given the illegality of transferring or assigning most pension payments, combined with the lack of regulatory oversight, have saddled investors with huge losses when they depend on income and capital preservation to provide for their living expenses.