S&P downgrades Puerto Rico: The turning of the wheel

February 5, 2014

Photo: Puerto Rico Treasury Secretary Melba Acosta (R) and Governor Alejandro Garcia Padilla at a press conference in response to S&P’s downgrade. (Source: Ustream) 

Standard & Poor’s has stepped forward as the first major rater to strip Puerto Rico of its “investment grade” imprimatur. Puerto Rico is now officially speculative-grade credit and the most widely held junk bond in muniland.

Considering the economic fundamentals, the downgrade was inevitable. Economic indicators in Puerto Rico have been plummeting with sales of cement crashing 16 percent last year and gasoline consumption dropping 5.3 percent in the same period. Bank capital in Puerto Rico has declined 4 percent year over year as the commonwealth shakes off lingering problems from the housing bust.

Puerto Rico has essentially been in recession since 2006, when a special Congressional tax preference expired. It responded by borrowing heavily in the municipal markets. The borrowing drew future government cash flows forward, gave an immediate boost to the economy and created problems for later municipal leaders who must now juggle all these demands for repayment.

Today’s leaders are to be commended for facing this enormous problem head on. But this debt monster cannot be tamed with short-term fixes. It will take years to right the imbalances in Puerto Rico’s finances, let alone spur economic growth and repair a wrecked balance sheet.

To meet the demands of an extraordinarily heavy debt load, Puerto Rico’s government has crippled the economy with increased tax rates. Tax collections from individuals have contracted, while corporate tax collections have soared. This has caused the tax base to become increasingly fragile and even more subject to a downward economic spiral. As the economy produces less and is taxed more, less money flows through the non-government part of the system, creating a negative feedback loop. The higher corporate taxes being paid by U.S. multinationals are potentially unconstitutional and make the revenue system less stable.

Tax revenues are the lifeblood of a government and its creditors. When the underlying system shows weakness (unless sharp and rapid cuts are made to expenses) liquidity can become constrained. Standard & Poor’s writes:

The downgrades follow our evaluation of liquidity for the Commonwealth, including what we believe is a reduced capacity to access liquidity from the Government Development Bank (GDB) of Puerto Rico. In a related action, we downgraded the GDB to ‘BB’, and the rating remains on CreditWatch with negative implications. We also believe that the Commonwealth’s access to liquidity either through GDB or other means will remain constrained in the medium term, even in the event of a potential issuance of debt planned next month. We believe that these liquidity constraints do not warrant an investment grade rating.

The GDB is the nexus of bond raising and money distribution in Puerto Rico. Its cash flow is the lubricant for government spending and repaying debts.

A more ominous statement in the S&P release said that the GDB is negotiating new “multi-year” bank credit lines. Bank loans are higher in the capital structure than bonds, so this could create pressure to repay more creditors:

We understand that the GDB is currently negotiating to have certain debt holders waive acceleration provisions and arranging for new multi-year external bank credit lines that could mitigate near-term liquidity risks. The $940 million total includes only the current additional capital requirements in the event of a one-notch downgrade.

Raters, which have meetings with issuers and sign confidentiality agreements, generally have better access to non-public information about a debt issued. Raters, of course, have the task of assigning “through the cycle” credit ratings that attempt to predict an issuer’s ability to repay debts through all parts of the economic cycle. Puerto Rico’s economic cycle has gone from bad to worse. S&P, sensing the shifting wind and increasingly constrained conditions, has indicated that Puerto Rico will be less likely to repay its creditors through the cycle.

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