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CROSS-SECTOR
ISSUER IN-DEPTH22 JULY 2015
ANALYST CONTACTS
Ted Hampton 212-553-2741VP-Sr Credit [email protected]
Emily Raimes 212-553-7203VP-Sr Credit [email protected]
Timothy Blake 212-553-4524MD-Public [email protected]
Thomas Aaron [email protected]
Brandan Holmes 212-553-6897VP-Senior [email protected]
Elena H Duggar 212-553-1911Senior Vice [email protected]
Anne Van Praagh 212-553-3744MD-Sovereign [email protected]
Commonwealth of Puerto Rico
Frequently Asked Questions AboutPuerto Rico's Fiscal and Debt CrisisAs Puerto Rico (Caa3 negative) and its related issuers face the mounting probability ofdefault, there are key questions about future recovery rates for bondholders, the likelihood ofPuerto Rico averting a default and what its restructuring might look like. This report answers:
» Bondholder Recovery: What do your ratings on various Puerto Rico securities imply forbondholders?
» Missed Trustee Payment: How do this month’s disclosures that Puerto Rico failed tomake a scheduled trustee payment on one type of debt and that it would seek to buyback another type affect your view?
» Economic Growth and Revenue: Can Puerto Rico’s economy recover fast enough togenerate sufficient government revenue to pay debt service?
» Pension Risk: When do you expect Puerto Rico’s pension fund assets to be fullydepleted, and how will that affect expenditures?
» Federal Role: Will the US federal government bail out Puerto Rico?
» Comparison to Sovereign Restructurings: What makes Puerto Rico similar to, ordifferent from, a sovereign nation restructuring its debt?
» Bond Insurance: Bond insurers loaned money to the Puerto Rico Electric PowerAuthority to prevent default. What are the implications of that decision for othercommonwealth obligations?
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This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page onwww.moodys.com for the most updated credit rating action information and rating history.
2 22 JULY 2015 COMMONWEALTH OF PUERTO RICO: FREQUENTLY ASKED QUESTIONS ABOUT PUERTO RICO'S FISCAL AND DEBT CRISIS
Q: What do your ratings on various Puerto Rico securities imply for bondholder recovery?A: Our ratings are based not only on the probability of default but also on the loss given default. Combining these two figures producesthe expected loss that our ratings express. Looked at another way, our ratings also convey our expectations for bondholder recoveries(see Exhibit 1). In the case of Puerto Rico, we believe that the probability of default is approaching 100%, and that losses given defaultare substantial. At present, we assume that the commonwealth will seek to restructure its debt in a consolidated fashion, affecting allbondholders to varying degrees.
Exhibit 1
Puerto Rico and related ratings fall within Caa3 and Ca catagories
Security Rating Outstanding Expected Recovery RateGeneral obligation (andcommonwealth-guaranteed)
Caa3/Neg $18,566,000,000 65% to 80%
COFINA Senior Caa3/Neg $6,244,000,000 65% to 80%COFINA Junior Ca/Neg $9,000,000,000 35% to 65%PRIDCO General Purpose RevenueBonds
Caa3/Neg $176,895,000 65% to 80%
Aqueduct and Sewer Authority(PRASA)
Caa3/Neg $3,852,450,000 65% to 80%
Municipal Finance Authority (MFA) Ca/Neg $781,220,000 35% to 65%Puerto Rico Electric Power Authority(PREPA)
Caa3/Neg $9,054,243,000 65% to 80%
UPR System Revenue Bonds Ca/Neg $470,775,000 35% to 65%UPR Educational Facilities RevenueBonds
Ca/Neg $68,700,000 35% to 65%
Appropriation-backed debt Ca/Neg $1,165,534,000 35% to 65%Government Development Bank notesCa/Neg $5,137,257,000 35% to 65%Highways and TransportationAuthority (PRHTA)
Ca/Neg $4,418,535,000 35% to 65%
PRHTA Subordinate TransportationRevenue Bonds
Ca/Neg $298,465,000 35% to 65%
Infrastructure Finance Authority(PRIFA)
Ca $1,889,303,000 35% to 65%
Pension Funding Bonds (ERS) Ca/Neg $2,948,000,000 35% to 65%Convention Center District AuthorityHotel Occupancy Tax Revenue Bonds
Ca/Neg $408,530,000 35% to 65%
Total $64,479,907,000
Sources: Government Development Bank, Moody’s Investors Service data.
As indicated by our ratings and shown in Exhibit 1, we believe that bondholder recoveries will be lowest on securities lackingexplicit contractual or other legal protections. These securities consist of those rated Ca, including notes issued by the GovernmentDevelopment Bank for Puerto Rico and the commonwealth’s subject-to-appropriation debt. We lowered the ratings on most of thesesecurities to Ca from ratings in the Caa range on May 21.
On July 1, after Governor Alejandro García Padilla declared that Puerto Rico could not pay its debt, we affirmed ratings on the Ca-rated bonds and also downgraded several other securities to that level. Legally protected securities consist primarily of generalobligation and guaranteed debt, of which more than $18 billion is outstanding. Constitutional provisions, such as Article VI, Section8, which gives GO bondholders a first claim on the government’s available resources, support these bonds. However, we downgradedeven those securities on July 1 for two reasons. First, it will be hard for the commonwealth to achieve significant fiscal relief throughdebt restructuring if it completely excludes GO and guaranteed bonds. The GO and guaranteed debt category accounted for one-third of the commonwealth’s net tax-supported debt in our 2015 Debt Medians report , and it also accounted for 43% of its annualdebt service burden, as of fiscal 2014. Second, the commonwealth had signaled that GO bonds would not be immune from its debtrestructuring, by suspending a legal requirement to make monthly set-asides for GO bond debt service.
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If the commonwealth cannot achieve a negotiated settlement, GO bondholders have the right to sue the commonwealth for a “claw-back” of revenues allocated to other bonds in order to make GO payments, under Article VI Section 2 of the constitution. As shown inExhibit 1, we still anticipate better recovery rates for GO and guaranteed bonds, as well as for the bonds we believe will be protectedfrom the claw-back mechanism. These include bonds issued by the Puerto Rico Aqueduct and Sewer Authority (PRASA) and the SalesTax Financing Corporation (COFINA) senior-lien revenue bonds. The claw-back mechanism, touted for many years as an immutablebondholder protection, has never been implemented. In the negotiated restructuring that Puerto Rico is seeking, we believe that thethreat of activating the claw-back mechanism will compel the government to offer somewhat higher remuneration to holders of GOand guaranteed bonds, at the expense of investors with securities vulnerable to the claw-back. This will tend to drive recovery rateslower for holders of subject-to-appropriation debt, GDB senior notes and other instruments that lack the strongest legal protections.Our working estimates are based on reductions in principal and interest payments of about 40% annually through 2023, factoring incuts of about 25% for Caa3-rated bonds and 55% for Ca-rated bonds. Implied recovery rates are 75% and 45% are in the middle of therespective Caa3 and Ca ranges. Our estimate, covering fiscal years 2016 through 2023, is based on a scenario in which the governmentchooses to reduce debt service payments to avoid operating deficits. It assumes flat tax revenue growth, steady levels of spending ongeneral government services, and the need to cash-fund retirement benefits for the commonwealth’s two largest pensions starting infiscal 2019. Actual losses will of course reflect factors that are difficult to assess at this point, such as the potential for a protracted legalprocess in which bondholders with differing agendas block implementation of a broad agreement.
Q: How is your view affected by Puerto Rico's failure to make a scheduled trustee payment and by theGDB's debt repurchase efforts?A: On July 15, Puerto Rico’s Public Finance Corporation (PFC) disclosed that it had failed to make a $93.7 million scheduled transferthat day to the bond trustee for payment on its approximately $930 million of outstanding debt. On July 9, the GovernmentDevelopment Bank for Puerto Rico (GDB, Ca negative) said it would “seek to purchase” its outstanding notes at prices expected to be“materially less than par.” Both of these disclosures were in line with our expectations. We downgraded both the PFC and GDB bonds,among others, to Ca negative on May 21. This action was driven by our conclusion that the central government and GDB, its fiscalagent, would pursue cash-conservation tactics that would lead to default and investor losses, particularly for securities not protectedby the strongest revenue pledges or constitutional provisions. This debt category, we believe, includes both the PFC and GDB securities.PFC’s bonds require annual legislative appropriation for payment, and bondholders have limited remedies if the legislature fails totake action. While the GDB has played a central role in Puerto Rico’s financial activities for many years, its securities lack specific legalsafeguards for bondholders, such as the constitutional provisions that support the commonwealth’s GO bonds.
At this point, we do not believe a default has yet occurred on either PFC or GDB securities, although both of the disclosuresdemonstrate the high likelihood and increasing imminence of default and bondholder losses. For the GDB securities, it is probable that
any bond buybacks would represent distressed exchanges, which we view as a form of default.1 More immediately, Puerto Rico facesa payment default on the PFC's subject-to-appropriation bonds because of legislative inaction. The PFC's scheduled August 1 paymentto bondholders is $58 million. The PFC’s obligation to transfer funds to the trustee on July 15 was contingent upon the passage ofappropriations that did not occur. As is typical of subject-to-appropriation bonds, legislative inaction alone does not constitute adefault. Corrective action from the legislature, which currently is not in session, appears unlikely before the August 1 payment date.
Q: Can Puerto Rico recover fast enough to generate enough government revenue to support its debt?A: Puerto Rico lacks an obvious engine of recovery, and some of the commonwealth’s primary economic sectors continue to contract.Employment in the pharmaceutical and medicinal manufacturing sector is estimated to have plunged more than 50% in the nineyears ending in 2014 (see Exhibit 2). One bright spot in the economy, tourism, accounts for comparatively small portions of bothemployment and economic output, and it also faces growing regional competition.
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Exhibit 2
Pharmaceutical manufacturing jobs have declined
Source: US Bureau of Labor Statistics
Given the weak job supply and the ease of migration to the mainland US, it is not surprising that outmigration has eroded PuertoRico’s economy for 17 consecutive years (see Exhibit 3). Labor force participation, at 40%, is a fraction of the nation’s 63%. Despitethe chronic population losses and Puerto Rico’s low labor-force participation, the percentage of workers who are unemployed is 12.6%,more than twice the nation’s 5.3%.
Exhibit 3
Population has steadily declined as Puerto Ricans move to the mainland
Source: US Census Bureau
Puerto Rico’s economic output will keep declining or stagnate in coming years, Moody’s Analytics projects. The commonwealth’snominal growth rate is projected at 0.4% this year and 0.6% in 2016. In order to sustain its existing debt load without cuts to non-debtexpenditures, we believe that the commonwealth would need sufficient economic expansion to generate tax revenue growth of almost7% in 2017 and about 2.5% a year thereafter. Currently, debt service to gross national product is 6.2%, relatively low by internationalstandards. The debt service burden is nevertheless onerous given the commonwealth’s lack of growth, accounting for about 14% of theconsolidated budget this fiscal year. Assuming no resurgence of economic and revenue growth, we estimate that the commonwealthcould support approximately 60% to 65% of its net tax-supported debt (excluding the Puerto Rico Electric Power Authority).
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Q: When will Puerto Rico’s pension assets be depleted, and how will that affect expenditures?A: Both the Teachers Retirement System (TRS) and Employees Retirement System (ERS) may fully deplete their assets in 2020, basedon our analysis. This timeline is closely aligned with that of the plan actuaries and assumes no further reforms for either plan. Planactuaries for TRS have also noted that because of the illiquid nature of plan assets, the ability of the pension fund to make benefitpayments could end even sooner.
Adverse investment performance or practices that undermine funding would obviously accelerate the pace of asset depletion. Forexample, the government is evaluating the use of pension assets for liquidity advances to its Treasury Department, with the Treasurysubsequently assuming responsibility for benefit payments. Currently, the pension funds reimburse the Treasury from plan assets afterit makes benefit payments to retirees. Pursuing this strategy could negatively affect the funds' ability to seek investment returns andcould accelerate asset depletion.
Once the plans’ assets are exhausted, Puerto Rico would switch to paying retiree benefits directly using only general operatingrevenues, which would greatly add to ongoing expenses. Estimated 2021 benefit costs for TRS and ERS participants combined are $2.3billion, or about 25% of general fund revenues that year, assuming no revenue growth until then.
The commonwealth so far has not mentioned reductions to employee pension liabilities in proposed debt-restructuring efforts. Thisapproach is consistent with US Chapter 9 bankruptcies in recent years, where pension liabilities have mostly been treated favorablyrelative to bondholders, and have even been completely unimpaired in several cases.
Should it seek to reduce pensions for expenditure relief, Puerto Rico faces legal uncertainty. The government's legal capacity todiminish benefits has been both affirmed and put in question by apparently conflicting rulings from the commonwealth’s SupremeCourt in recent years. In April 2014, the court struck down Act 160, a 2013 reform intended to maintain the solvency of the TRS andJudicial Retirement System by increasing minimum retirement ages and employee contribution requirements, and by implementinga defined contribution plan for future benefit accruals. Conversely, the court in 2013 had approved the constitutionality of Act 3, asimilar package of reforms for ERS, indicating that, in keeping with prior rulings, the court would allow reasonable reforms to maintainpension plan solvency. The court in 1987 had ruled that although public pension plan participants have contractual and vested rights totheir benefits, the legislature can allow for reasonable changes in benefits to promote a plan’s actuarial solvency.
Q: Will the US federal government bail out Puerto Rico?A: Any scenario resembling an outright bailout is highly improbable. Unlike in many other countries, the federal government does notprovide states or local governments with extraordinary funds to avert defaults on their debt, in part because doing so would induceother governments to take on unsustainable amounts of debt or engage in reckless fiscal practices. Our ratings assume that not onlywill there be no federal payment of debt service, but that the federal government’s efforts on Puerto Rico’s behalf will have onlymarginal near-term effects.
The commonwealth is seeking several specific measures from the federal government, such as improved Medicare payment termsand the ability to use the US Bankruptcy Code. The proposed bankruptcy measure (H.R. 870) would revise a portion of the bankruptcycode that, since 1984, has specifically excluded Puerto Rico from Chapter 9, which applies to public-sector reorganizations. PuertoRico’s non-voting member of Congress proposed H.R. 870 (also known as the Puerto Rico Chapter 9 Uniformity Act of 2015), andit has drawn support from prominent Democrats, but it still faces significant challenges. Even if Congress did reach a consensus onopening bankruptcy courts to the commonwealth, we would expect that a large portion of Puerto Rico’s debt would not be eligible forbankruptcy restructuring. States themselves cannot file for bankruptcy protection under Chapter 9. Since Puerto Rico is treated as astate under the Bankruptcy Code, only its authorized municipalities (or public corporations) that can demonstrate insolvency would beeligible for protection if H.R. 870 were enacted.
A bankruptcy filing might provide for a more orderly process with comparatively better recovery rates for a subset of bondholders,excluding direct debt of the central government as well as public corporations unable to show insolvency. Such a partial restructuringmight not be worth the effort, in view of Puerto Rico’s urgent pressures. Since Chapter 9 is unlikely to be a viable way to achieve aconsolidated restructuring of all the commonwealth’s debt, bankruptcy authorization would not be sufficient, by itself, to managePuerto Rico's current pressures.
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Congress could also seek to impose a fiscal and economic control board, as it did for the District of Columbia in 1995, after asuccession of operating deficits, cash shortfalls and identification of widespread management problems. The political hurdles toimposing a similar control board on Puerto Rico are high, given the broad powers with which such a control board would be endowed.Tangible benefits from implementing a control board would take time, and no legislation has yet been advanced to form a controlboard. Congress has explicit oversight of the nation’s capital pursuant to Article I Section 8 of the US Constitution, which madeCongress's imposition of a control board more straightforward and, arguably, imperative. Other support from Congress could comein the form of humanitarian assistance, if economic conditions deteriorate dramatically, or through amendments to the Jones Act of1920, which imposes high shipping costs on Puerto Rico.
Q: What makes Puerto Rico similar to, or different from, a sovereign nation restructuring its debt?A: Puerto Rico is in the unusual position of being similar to a US state, but lacking a state's full legal rights. It uses the US currency andreceives various forms of federal support, but it is self-governing, lacks real representation in Congress and, in some legal respects, istreated as a foreign jurisdiction under US law. Because of the US government's reluctance to intervene financially in any state or localdebt crises, we believe Puerto Rico's restructuring will play out largely along the lines of sovereign debt crises.
However, unlike Greece (Caa3 on review for downgrade), Puerto Rico cannot turn to a lender of last resort, such as the InternationalMonetary Fund or other supranational structures for oversight or financing. Another key difference between Puerto Rico and asovereign nation restructuring is the commonwealth's complex array of security types with varying contractual provisions and senioritylevels. National governments typically have fewer debt types, with differences relating to the treatment of domestic, external, officialsector and private sector creditors, rather than seniority of claim. The multiplicity of Puerto Rico's securities may complicate its effortsto reach a broad restructuring agreement with all creditors, even after a lengthy negotiation period.
Another difference is that most sovereign bonds include collective action clauses, which typically allow consent from 75% ofbondholders to bind all others to a restructuring plan. Puerto Rico’s contractual provisions lack collective action clauses, which mayfurther complicate matters. Additionally, some Puerto Rico bonds provide for New York legal jurisdiction and others for Puerto Ricocourts. Before the restructuring process can begin, these jurisdictional issues may need to be sorted out. Some sovereigns have dealtwith such parallel legal structures, though it can prolong recovery proceedings (see Exhibit 4).
Exhibit 4
Legal Features of Rated Defaults since 2000
Country Initial Default Date Distressed Exchange Date Governing Law Creditor StructureArgentina Nov-01 Nov-01 Local Law DispersedArgentina Nov-01 Feb-05 Eight Governing Laws DispersedMoldova Jun-02 Oct-02 English Law Concentrated
Nicaragua Jul-03 Jul-03 Local Law ConcentratedNicaragua Jul-03 Jun-08 Local Law Concentrated
Dominican Republic May-05 May-05 New York LawBelize Dec-06 Feb-07 New York Law Concentrated
Ecuador Dec-08 May-09 New York LawJamaica Feb-10 Feb-10 Local Law Concentrated
Greece Mar-12 Mar-12Local law and
some foreign lawDispersed
Belize Sep-12 Mar-13 New York Law ConcentratedJamaica Feb-13 Feb-13 Local Law Concentrated
Sources: Moody’s Investors Service, Sturzenegger and Zettelmeyer (2005), Diaz-Cassou, Erce-Dominguez and Vazquez-Zamora (2008), and Andritzky (2006). Sovereign DefaultsSeries: The Aftermath of Sovereign Defaults, October 2013
Still another difference between Puerto Rico's situation and sovereign restructuring is the commonwealth's diverse investor base.National government debt tends to be held by a few funds and domestic banks with large stakes, which makes negotiating arestructuring accord easier. Puerto Rico’s securities, by contrast, are widely dispersed among numerous kinds of investors: individuals,mutual funds and speculative holders such as hedge funds. For a given Puerto Rico bondholder, the degree of concentration in Puerto
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Rico debt tends to be small. This further suggests that the central government faces a daunting challenge to forge consensus with abroad range of investors.
The criteria for an eventual restoration of Puerto Rico's market access for new bond offerings will also likely differ from sovereignsthat re-enter the market following default. While many national governments in restructuring cases face challenges from devaluationof their currencies, Puerto Rico's main hurdle will likely be the ability to show that its economy has transcended the structuralimpediments to growth that have long weighed on it since 2006.
Q: Bond insurers loaned money to the Puerto Rico Electric Power Authority (PREPA, Caa3 negative) to preventdefault. What are the implications of that decision for other commonwealth obligations?A: The $128 million of bridge loans that insurers provided allowed PREPA to make its July 1 debt service payment in full, avoidinga default. Delaying an actual default or debt restructuring, and establishment of the ultimate loss severity, helps the guarantors inseveral ways .
First, a default would have disrupted ongoing negotiation between PREPA and its creditors. Continuing the dialogue, outside of adefault situation, may improve recovery prospects. The guarantors’ support for PREPA’s July principal payment was the first concreteand material evidence that the guarantors and PREPA are having ongoing constructive dialogue to resolve PREPA’s operational andcapital structure challenges, increasing the likelihood of higher recoveries in the event of a default. It also underscored the guarantors’extensive workout expertise and the variety of tools that they can use to contribute to the debt restructuring process. These toolsinclude not only the ability to provide financing, but also the ability to insure bonds to assist with post-restructuring market access. Theinsurers have a contractual basis to assert control rights in an event of default, and their long time horizons allow a patient approach inworking towards an optimal solution.
Second, having more time until a restructuring or default works in guarantors’ favor. As time passes, and given limited new businessactivity, guarantors’ insured portfolios amortize and premium revenues are recognized, contributing to improved regulatory andeconomic capital profiles, dampening the effect of a Puerto Rico loss. Also, under GAAP and statutory accounting rules, guarantorsrecord losses based on a probability-weighted range of outcomes. This means that the actual reported losses reflect guarantors’perception of the range of possible losses and is not simply driven by a default or the insurance coverage, and as long as constructivenegotiations with PREPA are underway, the guarantors are likely to report relatively small loss reserves.
This development with PREPA is just one aspect of the ongoing Puerto Rico debt crisis. Before the July debt service payments,Assured and MBIA each had approximately $4.9 billion in aggregate net exposure to Puerto Rico, including PREPA debt. Although theguarantors’ support arrangement with PREPA was a positive step, the situation remains fluid.
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Moody's Related Research
» Study Advising Debt Restructuring Casts Doubt on GO Bond Protections, June 2015 (1006242)
» Puerto Rico's General Obligation Bonds Face Threat from Bill Allowing Suspension of Monthly Debt-Service Deposits, June 2015(182696)
» Puerto Rico Electric Power Authority: Frequently Asked Questions About PREPA, March 2015 (1003487)
To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of thisreport and that more recent reports may be available. All research may not be available to all clients.
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Endnotes1 A distressed exchange occurs when an obligor offers creditors a new or restructured debt or a new package of securities cash or assets that amount to a
diminished financial obligation relative to the original obligation, and the exchange allows the obligor to avoid a future payment default or bankruptcy.
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MJKK or MSFJ (as applicable) hereby disclose that most issuers of debt securities (including corporate and municipal bonds, debentures, notes and commercial paper) and preferredstock rated by MJKK or MSFJ (as applicable) have, prior to assignment of any rating, agreed to pay to MJKK or MSFJ (as applicable) for appraisal and rating services rendered by it feesranging from JPY200,000 to approximately JPY350,000,000.
MJKK and MSFJ also maintain policies and procedures to address Japanese regulatory requirements.
MOODY'S INVESTORS SERVICE CROSS-SECTOR
11 22 JULY 2015 COMMONWEALTH OF PUERTO RICO: FREQUENTLY ASKED QUESTIONS ABOUT PUERTO RICO'S FISCAL AND DEBT CRISIS
AUTHORSTed HamptonTom AaronElena DuggarBrandan HolmesShivani PatelEmily RaimesAnne Van Praagh
