Is Puerto Rico following Argentina’s path?

The mysterious borrowing undertaken by the Puerto Rico Government Development Bank in the middle of December has been explained. The GDB issued a press release that said that it had “borrowed” $110 million from the state workers insurance fund:

Government Development Bank for Puerto Rico (GDB) Interim President José Pagán Beauchamp today confirmed the GDB’s placement of $110 million in Senior Guaranteed Notes with the Puerto Rico State Insurance Fund Corporation. The bonds have a coupon of 8 percent per annum and have maturities of $40 million, $30 million and $40 million on December 1, 2017, December 1, 2018 and December 1, 2019, respectively.

It looks like a desperate grasp for liquidity. The GDB, however, calls it a plus for the state workers insurance fund that it “borrowed” assets and improved its cash flow.

‘This transaction is a part of our previously announced strategy to bring Commonwealth deposits to the GDB,’ said Pagan. ‘It achieves two objectives simultaneously – increasing GDB’s liquidity and improving the cash flow of the State Insurance Fund. Combined with fiscal reforms recently signed into law that will strengthen the teachers’ pension system, today’s announcement reflects another step in improving the Commonwealth’s near-term economic situation and long-term economic outlook.’

The interest rate on this intergovernmental borrowing for 4, 5, and 6 year loans is 8 percent – extremely high. Here is how Puerto Rico said it would address its cash needs last October when it said it had sufficient liquidity through fiscal year 2014 (June 30):

Puerto Rico’s GDB borrows again

Muniland’s most closely watched issuer, Puerto Rico, borrowed last week, according to a notice filed with the Municipal Securities Rulemaking Board’s EMMA system. There was no official statement, but the securities have CUSIP identifiers.

The Government Development Bank was the obligor and there are three maturities: 2017, 2018 and 2019. The GDB is rated Baa3 by Moody’s (under review with the PR general obligation ratings). All three maturities were borrowed at 8 percent. Thomson Reuters MMD Baa3 yield curve for Baa credits was 1.95 percent for 2017, 2.39 percent for 2018 and 2.93 percent for 2019. For the 2017 maturity, Puerto Rico paid four times the benchmark rate.

Many have speculated that if Puerto Rico were to issue a third lien series of Cofina bonds, that longer maturities would have to be priced around 8 percent or higher. But given the 4 to 6-year borrowing at 8 percent that the GDB did last week, Cofina might have to price even higher, even though Cofina has stronger guarantees for repayment. The Bond Buyer reported that Puerto Rico municipalities might issue a variant of Cofina bonds:

The many market views of Puerto Rico

“That is what makes markets” is a financial industry aphorism that means there can be a broad spectrum of views about an asset or a specific security. This is most true for the municipal bonds of Puerto Rico.

With the darkest view of Puerto Rico bonds, BlackRock’s Managing Director and Head of Municipal Bonds Group Peter Hayes told Fox Business News that the Commonwealth may have to restructure its debt “somewhere between now and the middle of 2014 when their fiscal year begins.”

In this Reuters Insider MuniLand video, Emily Raimes, Senior Credit Officer at Moody’s, outlines the fiscal and economic factors that her ratings team will be evaluating after placing Puerto Rico on negative credit watch last week.

A note to New York Fed President William Dudley

Dear President Dudley:

Although it is a longstanding policy of the Federal Reserve not to intervene in the finances of state and local governments, it may be time to reconsider this policy in the case of Puerto Rico. A member of your board of directors, Richard Carrión the CEO and Chairman of Banco Popular de Puerto Rico, wrote to The Economist about the state of Puerto Rico’s finances:

You said that the effect on economic activity by new levies on businesses would negate half of the expected increase in revenues, but you overlooked easily available data showing that net government revenues were $350 million during the first fourth months of the current fiscal year, $120 million higher than forecast.

Mr. Carrión is correct about Puerto Rico’s success in increasing tax collections, but its economy continues to contract. From Reuters:

Will Puerto Rico’s contracting economy lead to default?

Justin Vélez-Hagan is the executive director of the National Puerto Rican Chamber of Commerce, a small non-profit not to be mistaken with the much larger Puerto Rico Chamber of Commerce.  Vélez-Hagan argues in a recent Forbes opinion piece that Puerto Rico must default on its debt:

Washington politicos aren’t the only ones instigating a perpetual debt crisis.  Puerto Rico too is experiencing a political stalemate-induced fight for their financial lives that affects not only its 3.7 million residents, but millions of others who have purchased bonds to help finance its government, causing us to wonder if the next logical step is a debt default.

Here is his rationale:

Many experts say Puerto Rico is entering the eighth year of a recession, with at least one who considers it to be in the midst of an all-out depression.  Gustavo Vélez, former economic adviser to the governor, is one such analyst, acknowledging that the economy has been kept afloat by increasing taxes, with little or no effort to fix underlying structural problems.

Puerto Rico’s new liquidity providers


There are plenty of stories about how hedge funds are being lured into buy Puerto Rico debt by big dealers. The Wall Street Journal wrote about hedge funds buying distressed debt. Bloomberg reported that Morgan Stanley, Citigroup and Lazard are holding information sessions for hedge funds to learn about Puerto Rico debt. A trader passed me the presentation from the Citi meeting. It was a detailed explanation of the seniority of Puerto Rico debt and the legal covenants and trading history of specific Puerto Rico issuers and authorities. I would guess Morgan Stanley and Lazard did an equally good job on the background for their clients.

Everyone in fixed income markets has been hunting for yield. It’s easy to see how Puerto Rico debt, with its hefty yields, could be attractive to alpha-searching hedge funds. Hedge funds can’t take advantage of the municipal bond tax exemption, so yields for them are not as high as they would be for a risk-loving retail investor. But hedge funds have the advantage of using leverage to buy assets. This leverage usually comes in the form of loans from the hedge funds’ prime broker. Prime brokers are the large dealer banks that provide financing, trading and back-office services to their hedge fund clients. Morgan Stanley is the second-largest prime broker in the U.S. and Citigroup is seventh largest, according to Hedge Fund Alert. These two dealer banks were prime brokers to about 1,800 hedge funds in the first quarter of 2013.

Hedge funds and other buyers that don’t to take advantage of the tax exemption are referred to as crossover buyers. The Federal Reserve does not track the holdings of hedge funds in its “Financial Accounts of the United States” report, (page 98) so we have no official data on how many hedge funds are buying municipal bonds.

Ratings competition is good for muniland

Morningstar Ratings began when it purchased the respected independent rater Realpoint in 2010. Realpoint was only registered to rate structured finance products, and Morningstar has leveraged that authority to begin rating muniland.

Morningstar Ratings, as a Nationally Recognized Statistical Rating Organization (NRSRO), has to do a lot to prove its chops against bigger competitors Fitch, Moody’s and Standard & Poor’s.

I’ve been pushing for more competition among raters since 2003, so I think the entrance of Morningstar and others is fantastic. Markets benefit from more opinions. Shaking up the ratings business is needed for more timely and accurate ratings.

Puerto Rico unveils a plan


Puerto Rico’s top public officials held a two-hour conference call on Tuesday that was open to all investors. That may have been a first for the Commonwealth. Previous calls and conferences had been relatively restrictive in who was admitted. The yields on Puerto Rico’s debt have skyrocketed and the Commonwealth’s access into the public debt markets has been basically shut down. The open conference call was a good change of approach.

Bond investors want to hear the facts about Puerto Rico’s fiscal condition and how they will be repaid on their investments. The call made some progress toward that goal.

The economic and fiscal situation in Puerto Rico is still extremely dire. The economy is mired in a six-year malaise that would be worse if the Puerto Rico government had not issued debt to cover government deficits. As the island has moved away from issuing debt to plug holes in the budget, it has simultaneously reduced the amount of fiscal stimulus that has been injected into the economy. The economy shrank 5.4 percent year over year in August. It will likely shrink more as the Commonwealth reduces its deficit financing.

Puerto Rico tax revenues must pick up pace

Puerto Rico announced first quarter general fund revenues for fiscal year 2013/14. As you can see, revenues increased $71 million year over year. But the Puerto Rico budget projected that corporation taxes would increase $775 million for the full year. They need to rapidly increase.

If general fund revenues continue on this pace, they will annualize at around $7.3 billion for the year. Puerto Rico will need a massive surge in the coming quarters to meet the full year budget estimate of $9.7 billion in general fund revenues (page 14).

Puerto Rico’s moral hazard

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.

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