SEC Goes Fishing for Fraud in Puerto Rico

October 27, 2013 Leave a comment

SEC Goes Fishing for Fraud in Puerto Rico

Many municipal-bond funds own at least some debt issued by the U.S. territory of Puerto Rico because the tax advantages and high yields boost returns. So it was interesting to find an article in the Bond Buyer reporting that the Securities and Exchange Commission is “probing” some mutual funds because they invest in Puerto Rican debt. According to a letter from the SEC’s San Francisco office obtained by the newspaper, the agency is checking whether funds “are adequately disclosing the risks involved.” The SEC is also asking for the funds’ “policies and procedures used to value portfolio positions,” including “copies of the most recent stress test” and “Value-at-Risk analysis.”This seems odd. The SEC’s mission is to protect investors from fraud and misleading information. But any prospective investor can check what a mutual fund is holding before deciding to buy shares. If the SEC thinks risks aren’t being adequately disclosed, it should go after the issuers of the debt, not the bond funds. It also isn’t the SEC’s job to second-guess the risk models of mutual funds, even if the widespread holdings of Puerto Rican debt constitute a systemic threat to the financial system. There are other agencies of the U.S. government with that responsibility, including the Federal Reserve and the Financial Stability Oversight Council.

I do hope those other agencies are looking into the risks posed by Puerto Rican debt. The Economist magazine is now comparing Puerto Rico to Greece. This isn’t a stretch: An inappropriate currency union and a poor business climate have produced chronic underemployment and a poverty rate of 45 percent. Despite regular monetary transfers from the mainland, the local government has run large budget deficits for years — something the 50 states aren’t allowed to do. The result is a tax-supported municipal debt burden equal to almost 90 percent of personal incomes, although it should be noted that Puerto Rican residents pay no federal taxes.

If Puerto Rico does end up restructuring its tax-supported general-obligation bonds, it might spark a panic affecting many other instruments. For one thing, the territory, like many municipal bond issuers, also issues debt backed by dedicated income streams such as tolls and hospital fees. These revenue bonds have a different credit profile than the general-obligation debt, but that subtlety might be lost on many investors spooked by talk of default and restructuring. (Just look at what happened in Michigan after Detroit declared bankruptcy.) Other U.S. territories, such as Guam and the Virgin Islands, might become unfairly stigmatized because of Puerto Rico. The worst-case scenario would be a general run on municipal borrowers as investors search for mutual funds that aren’t exposed to the troubled island.

These are serious issues that deserve the attention of experts with eyes on all parts of the financial system. That isn’t strictly the job of the SEC, so the Fed and FSOC ought to be involved. We should hope that regulators began studying this before the rout suffered by certain Puerto Rican bonds over the past few months.

(Matthew C. Klein is a writer for Bloomberg View. Follow him on Twitter.)

Filed under Macro Trends

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Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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