Puerto Rico’s moral hazard

October 3, 2013

Puerto Rico’s short term funding needs are sending out warning bells. The Padilla Administration has been pushing the Commonwealth Legislative Assembly to agree to an increase in the Sales Use Tax to 3.5 percent from 2.75 percent. With this diverted revenue, the government could issue a third series of Cofina bonds for approximately $2 billion. This third tranche would be subordinate to the first two series of Cofina bonds, but have higher ratings than PR general obligations bonds and other public authority debt. The additional Cofina debt may be needed for short-term borrowing done through private placements.

El Neuvodia reports on the action in the Legislative Assembly (translated from Spanish):

Although they stressed there is ‘no rush’ to go to the markets, the principal officers of the prosecution team of Alejandro García Padilla administration today defended the move in a joint public hearing of Finance committees in the House and Senate.

‘We need to refinance this debt,’ said Interim President of GDB, José V.Pagan, referring to $1.223 million that would have been used to cover the daily expenses of the government.

Meanwhile, Debtwire ran an unsourced story that said U.S. government officials would consider backstopping a new issue of Puerto Rico bonds:

‘Given the potential for Puerto Rico’s financial challenges to impact U.S. markets, including the municipal market, Treasury continues to closely monitor developments,’ a Treasury spokesperson told the publication.

Citing unnamed sources, the report said the Treasury Department could backstop new debt issued by Puerto Rico’s Government Development Bank by pledging to purchase a certain amount ahead of the deal, which could create the market conditions for Puerto Rico to effectively issue more debt.

‘If you can bailout AIG, you can bailout the GDB,’ one unnamed source told Debtwire.com, referring to the Federal Reserve’s $85 billion loan to the international insurance company in September 2008.

The moral hazard alarm is going off. In one sentence, the issue of a “bailout” and a “loan” is raised. Although the Debtwire report has not been confirmed by reports in other media, it is concerning.

The threshold for emergency public loans has been whether the receiving entity was solvent and was only suffering from a short-term liquidity problem. The Federal Reserve did not lend to Lehman Brothers because the bank’s balance sheet was full of bad long-term assets and it had massive leverage through short-term borrowings. It was not solvent. Could the same be said of Puerto Rico and its Government Development Bank? I wrote previously:

The GDB, like any financial institution, has to be evaluated on its balance sheet. The bank solely relies on loans it makes to collect revenue and repay other loans. All the borrowers from the GDB are public corporations, government agencies or Puerto Rico municipalities. Net assets of the bank were $2.21 billion as of March 31, 2013. It carries a BBB- rating from Standard & Poor’s (page 59).

GDB bond Cusip 745177FN0 due 2019 has continued to trade above 13 percent (taxable), which suggests that the market believes the GDB has substantial risk for making bond and principal payments down the road. The Federal Reserve can lend to Puerto Rico under Federal Reserve Act Section 14 (2)b1, which says:

To buy and sell, at home or abroad, bonds and notes of the United States…having maturities from date of purchase of not exceeding six months, and bills, notes, revenue bonds, and warrants with a maturity from date of purchase of not exceeding six months, issued in anticipation of the collection of taxes or in anticipation of the receipt of assured revenues by…, a foreign government or agency thereof, such purchases to be made in accordance with rules and regulations prescribed by the Board of Governors of the Federal Reserve System.

Section 14 (2)b2 says that if bonds are guaranteed by the U.S., the Fed can buy them at any maturity:

Notwithstanding any other provision of this chapter, any bonds, notes, or other obligations which are direct obligations of the United States or which are fully guaranteed by the United States as to the principal and interest may be bought and sold without regard to maturities but only in the open market.

The Fed could certainly step in to put a floor under the trading of Puerto Rico debt. But how long would that last until Puerto Rico’s economic conditions would support its debt service? The broader problem for Puerto Rico is that a large group of regular buyers have publicly stepped away from buying the bonds. For example, the Wall Street Journal reported on the major brokerages that are limiting retail investors’ access to PR bonds:

Large brokerages are limiting small investors’ access to Puerto Rico’s debt amid deepening unease about the island commonwealth’s financial health.

UBS AG and other firms have separately warned more than 40,000 U.S. financial advisers and brokers to steer clear of about $70 billion of Puerto Rican debt currently on the market, according to people familiar with the matter.

Reuters reported that local market Puerto Rico investors were getting hit with large losses in closed end funds (emphasis mine):

The steep decline in prices of Puerto Rican bonds on the American municipal bond market is taking a heavy toll at home, where local institutions and individuals own an estimated 30 percent of the $70 billion of outstanding bonds.

Heightening worries in recent months about Puerto Rico’s shrinking economy, double-digit jobless rate and per capita debts far higher than in any U.S. state touched off a wave of selling and briefly pushed some Puerto Rico yields to over 10 percent.

The yield on Puerto Rico’s general obligation 30-year bond hit a recent peak of 8.58 percent, up from 5.49 percent on June 30. The steep drop in prices, which move inversely to yields, has hit local banks and closed-end and mutual funds marketed to bond buyers in Puerto Rico. Some of the Caribbean island’s bonds fell to as low as 60 cents on the dollar.

Now a bunch of local market investors are calling their attorneys. Reuters again:

Attorneys specializing in securities industry cases estimate losses tied to the sell-off of as much as hundreds of millions of dollars for the year, though Financial Institutions Commissioner Rafael Blanco said it was “impossible” to accurately tally the damage.

The Financial Institutions Commissioner does not track the substantial investments made by island residents through state-side brokerages, nor the holdings of insurers or pension funds.

Local attorney Harold Vicente, who said he is preparing arbitration action against UBS Puerto Rico on behalf of 15 or more clients, said an initial review showed losses among his clients of ‘tens of millions of dollars’ Some retirees, he said, were ‘totally wiped out.’

The U.S. Treasury or Federal Reserve could find the means to intervene in the market for Puerto Rico. But how long would the support have to last? And what if Illinois comes knocking at the door?

One comment

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I have purchased some PUERTO RICO AQUEDUCT AND SEWER AUTHORITY REVENUE BONDS (BB+) [long bonds @ ~7% yield between 07/19/13 and 07/29/13] based on the assumption that Water/Sewer “Revenue” bonds are safer than General Obligation bonds. Does my assumption hold any water?

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