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

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.

Puerto Rico’s solvency may hang on a potentially unconstitutional corporate tax

Last June, I asked if the U.S. Treasury was bailing out Puerto Rico with an unusual interpretation of the federal tax code. This waiver or exemption allowed U.S. multinationals operating in Puerto Rico to credit taxes that were paid to Puerto Rico on their federal tax bill. The tax, referred to as Act 154, was passed by the Puerto Rico legislature in 2011. It brought in approximately $1.6 billion in 2011.

When preparing its 2014 budget, Puerto Rico had a massive $1.5 billion deficit to fill. The governor had proposed expanding the “sales and use tax” (SUT or Cofina) by 73 percent, but this was met with strong resistance from the business community. The corporate excise tax (Act 154) was raised and part of the budget deficit was filled (an $800 million deficit is still projected for the current fiscal year).

Last week an excellent explanation of the corporate excise tax was published by Martin Sullivan on The Tax Analysts Blog. Sullivan highlighted the tax’s importance at 20 percent of general fund revenues:

Negative signals from Puerto Rico

The condition of Puerto Rico’s economy is a key concern for bond investors and rating agencies. Although its tax revenues have risen sharply as the government has increased various taxes, the economy has been contracting. From a recent Morningstar report:

The contracting economy remains a core concern for us, as Puerto Rico has now experienced 12 consecutive months of economic contraction relative to last year, and the monthly decline in economic activity in the first half of fiscal 2014 has been the most rapid since fiscal 2010.

Puerto Rico measures its economy using the PR Economic Activity Index. The EAI is made up of four components: payroll employment, cement sales, gasoline consumption and electricity generation. Although most December economic figures have not been publicly released, Standard & Poor’s ominously placed Puerto Rico general obligation and appropriation debt on “CreditWatch with negative implications” on January 24th. S&P rates Puerto Rico BBB-, its lowest investment-grade rating:

Will Puerto Rico sell general obligation bonds?

The New York Times reported that Morgan Stanley is shopping a potential $2 billion general obligation bond deal for Puerto Rico. Bloomberg followed up with a story that had a few more details about the offering that Puerto Rico supposedly has not authorized. According to Bloomberg the possible deal terms are:

The taxable general-obligation deal said to be under discussion would have maturities of at least five to seven years. The funds [hedge funds and distressed debt buyers] would assist the commonwealth as it struggles to turn around its shrinking economy. The discussions have cited possible yields of about 10 percent, the people said.

Let’s break this proposed issue into several pieces:

Taxable: Issuing taxable municipal bonds makes sense because it attracts a broader base of investors (including hedge funds, commercial banks and some insurance firms) outside of muniland that don’t take advantage of the municipal bond tax exemption. But the extremely high interest rate is a signal to any bond investor that the security has very high risk, regardless of its investment-grade rating from the three major raters. So we can rule out banks and insurance companies as buyers.

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.

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.

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