special commentary puerto ricos challenge march 2012

Puerto Ricos debt has long been attractive to municipal investors. The Commonwealths bonds carry high yields and are exempt from local, state, and federal income taxes. However, the Commonwealth today is flirting with insolvency, and the risk is growing that someday, Commonwealth investors may not be repaid, in full. Puerto Ricos financial condition is far worse than any U.S. states, and a default though unlikely in the immediate future is a possibility over the next few years. Breckinridge has long avoided obligations of Puerto Rico, but we believe all municipal bond investors should now be cognizant of its problems. A Commonwealth default would have significant ramifications for the municipal market. In this Special Commentary, we introduce the Commonwealth and its financial situation, and we speculate on the market impact of a Puerto Rico bond default. Our discussion begins with a brief introduction to the Commonwealths governance, the status issue, and its economy. It next moves to an overview of the islands poor financial condition. We then discuss how recent reform initiatives coupled with the lack of a trigger event make a default unlikely, at least in the near term. We conclude with a discussion of such a defaults impact on the market and the legal precedents that might emerge from it. advisor, and primary lender to the Commonwealth, its political subdivisions, and its public corporations. Puerto Ricos growth and financial stability require a healthy GDB.

The Status Issue

A perennial issue for Puerto Rico and its politicians is whether to support applying for U.S. statehood. The islands major political parties are divided on this policy matter, known as the status issue. A Commonwealth default would likely compel a national discussion of the status issue. It is uncertain how this discussion would unfold and what it might mean for Puerto Ricos bonds. 3 However, the Commonwealths current Governor supports statehood.4

Economy
The Puerto Rican economy entered recession in late 2006, and it has yet to emerge. Rising oil prices, government downsizing, and the end of tax advantages for manufacturers were the immediate causes of recession. 5 The Great Recession compounded the islands problems.

Puerto Ricos Real GDP Growth has been Negative or Modest for Several Years
source: Government Development Bank for puerto rico
1.0% 0.5% 0.0% 0.5% 1.0% 1.5% 2.0%

An Introduction to the Commonwealth: Government, Politics, Economy, & Recession

Government
The Commonwealth closely resembles a U.S. state. It has a bicameral legislature, and its governor is elected to a four-year term. The islands judicial system is indistinguishable from a state court system.1 However, Puerto Rico is unique in its extensive use of public corporations to deliver public services. It directly and indirectly manages 48 public benefit corporations. 2 This governance structure has tended to limit transparency and fiscal accountability in its public sector. The islands most important public corporation is the Government Development Bank (GDB). The GDB is the fiscal agent, paying agent, financial

2006

2007

2008

2009

2010

2011

Forecast

2012

2.5% 3.0% 3.5% 4.0% 4.5%

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SPECIAl CoMMENTARY, March, 2012

The islands recent economic quagmire also results, in part, from decades of industrial policy. Since the 1950s, the Commonwealth has invested heavily in infrastructure, education, and the development of high-tech manufacturing to spur growth. Concurrently, the federal government has subsidized Puerto Ricos debt through triple-tax-free bonds, 6 Puerto Rican manufacturers through corporate tax breaks, 7 and Puerto Rican residents through direct transfer payments. 8 These investments and subsidies have raised basic living standards.9 However, median household incomes in Puerto Rico remain at $15,000, and only 35% of Puerto Ricans are employed.10 Also, dependence on federal tax incentives and transfer payments has limited the islands long-term growth prospects.11 A Rising Debt Burden: Annual deficit financing has caused the islands debtto-GDP ratio to rise. It is now 90%, compared to 57% in 2001.13 In fiscal years 2011 and 2012, the Commonwealths debt load grew while the economy contracted.14

Puerto Ricos Debt Burden is High and Growing

note: Figures exclude unfunded pension and retiree healthcare oblications. source: Government Development Bank for puerto rico

Puerto Ricos Financial Condition is Weak

Poor financial management has contributed to the length and depth of Puerto Ricos recession. The Commonwealth is burdened by large annual deficits, a high debt burden, opaque financial practices, and severely underfunded pension plans, among other problems. The credit characteristics we highlight below are not new, but they have worsened dramatically over the last decade: Annual Deficits: The Commonwealth has not balanced its budget in twelve years. The FY 2012 deficit (this year) will be roughly $1.4 billion or 17% of general fund expenditures.12 This calculation excludes the accrual of annual pension expense.

The Commonwealth has Experienced Twelve Consecutive Deficits

source: official statements, public improvement refunding Bonds, series 2012a, p. 113, February 1,2012 and Government Development Bank for puerto rico, senior notes, series 2011a, p. 1-2, February 12, 2011.
$0 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11

Inflexible Debt Structure: Puerto Ricos debt structure is less flexible than other municipal issuers. The Commonwealth repays only 21% of its debt within 10 years.15 This means there is little potential to free up cash by extending maturities through refinancing. Politically Weak Bondholders: Relatively few Puerto Ricans own the islands bonds.16 Municipal debt is typically owned by resident taxpayers who pressure their politicians to avoid bond defaults, but Puerto Ricos creditors have a more limited voice in its politics. Poor Forecasting: Puerto Rico consistently adopts aggressive economic and financial forecasts. The Government Development Bank has missed economic growth forecasts for three consecutive years.17 Politicians continue to tout progress on relatively weak financial and economic data.18

-$500

$1,000 Deficit ($ millions)

-$1,500

-$2,000

-$2,500

Puerto Ricos Growth Forecasts are Routinely Aggressive

source: Government Development Bank and official statements from bond offerings.
-$3,000

-$3,500

GNP Growth (%) Forecast FY 09 -3.4 0.7 1.0 0.7 FY 10 FY 11 FY 12

Actual -4.0 -3.8 -0.4 ?

Deficit Financing: The Commonwealth has issued debt to finance its annual deficits. Unlike healthy municipal issuers, the Commonwealth requires market access to meet payroll and other obligations.

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SPECIAl CoMMENTARY, March, 2012

Opaque Intra-governmental Borrowing: The Commonwealths major public corporations have significant and opaque financial relationships to each other and to the Commonwealth.19 These intra-governmental capital flows represent a significant portion of the islands financial activities20 and they are beginning to impact the islands larger issuers. Last year, almost 28% of PREPAs (Puerto Rico Electric Power Authoritys) unpaid bills were owed by delinquent public sector organizations. 21 A Strained Government Development Bank (GDB): The Commonwealths vital Government Development Bank (GDB) is under stress. Roughly 35% of the GDBs assets comprise loans to the Commonwealth and its public entities, and most of these loans are paid late. 22 While the banks liquidity is ostensibly strong, it is weakly monitored. The GDB is unregulated by the Federal Reserve or Federal Deposit Insurance Corporation. 23 An Increasingly Politicized Government Development Bank: The GDBs loan book has become a bit politicized. In recent years, the GDB has entered into fiscal oversight agreements with several of the islands large public corporations. 24 These agreements require the public corporations to implement expense reductions, rate hikes, or submit to increased oversight to ensure the GDB is repaid. The banks intervention into areas traditionally reserved for policymakers increases its repayment risk. Underfunded Pension Plans: Puerto Ricos public pension funds were 14% funded in FY 2010, 25 and a staggering 22% of the funds assets include loans to members of the fund. The Employees Retirement System may deplete its net assets by FY 2014 despite recent reforms. 26 The Commonwealths pension funding shortfall is far worse than any U.S. state.

Recent Reforms and lack of a Trigger Event Suggest a Near-Term Default is Unlikely
Despite its poor economic and financial profile, the risk of a near-term default by Puerto Rico appears slim. Recent reforms appear sufficient to delay (if not forestall) a default. Equally important, the trigger events most likely to induce a Puerto Rico default seem unlikely.

Reforms
The Commonwealth has implemented a series of financial reforms during the past two years that have positively impacted its credit quality and growth prospects. These reforms (outlined below) include: overhauling the tax system, 27 streamlining the islands licensing and permitting process, 28 reducing government expenditures, 29 establishing a framework for public-private partnerships (essentially privatization of state assets), 30 and several changes to the pension system. 31

Puerto Rico has Enacted Several Important Fiscal Reforms over the Past Two Years
Jan-09 Feb-09 mar-09 apr-09 may-09 Jun-09 Jul-09 aug-09 sep-09 oct-09 nov-09 Dec-09 Jan-10 Feb-10 mar-10 apr-10 may-10 Jun-10 Jul-10 aug-10 sep-10 oct-10 nov-10 Dec-10 Jan-11 Feb-11 mar-11 apr-11 - Reduction of corporate and individual income tax rates, enhanced tax compliance, and reduction in tax credits and exemptions to spur growth and increase tax collections. (acts 154/171, november 2010. - Establishing an early retirement incentive which had a positive effect on pension systems actuarial value. (act 70, July 2010) - Creation of a new energy policy to reduce dependence on costly oil and foster renewable energy technologies. (acts 82/83, July 2012) - Overhaul of burdensome licensing and permitting processes to stimulate growth and entrepreneurship. (act 161, December 2009) - Creation of a public-private partnership mechanism (effectively a privatization law) to raise cash and restructure the management of state assets. (act 29, June 2009) - Gradual reduction in operating expenditures (act 7, march 2009) - Imposition of temporary and permanent tax hikes (act 7, march 2009)

note: Figures are for 2010. Data for california reflects plans for state employees, only, and excludes teachers and public agency employees. excludes pension reforms made for fiscal years beginning after June 30, 2010 source: merritt research services, llc
100%

Puerto Ricos Pension Shortfall Far Exceeds That of other States

% of pension liability actuarilly funded with assets

90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 14% 45% 61% 53% 71% 63%

may-11 Jun-11 - Immediate capitalization of pension funds with $163 million from the commonwealths infrastructure Financing authority. (act 96, June 2011) - Lower the maximim amount a member can borrow from the employees retirement system pension fund from $15,000 to $5,000 to improve the systems liquidity. (new regulation enacted by the Board of trustees of the employees retirement system, august 2011)

Jul-11 - Increase in employer contributions to the pension system (acts 114/116, July 2011)
Puerto Rico Illinois Connecticut Rhode Island California New Jersey

aug-11 sep-11 oct-11 nov-11 Dec-11

SPECIAl CoMMENTARY, March, 2012

Puerto Ricos economy is now nearing expansion. 32 Tax collections have also improved, and the newfound ability to lease assets has buoyed the Commonwealths cash flow. 33 Additional leases are planned, which should further improve short-term liquidity and limit default risk. for Puerto Rican manufacturers in 2006. Many of the companies affected by the change moved jobs off the island or restructured their corporate charter. It is likely a majority of job losses resulting from the 2006 tax change have already materialized.

Trigger Events
Importantly, the events most likely to set in motion a default seem unlikely in the near term. These mostly include risks associated with Puerto Ricos dependence on the capital markets and federal government. Because it borrows frequently to fund operations, the Commonwealth must retain market access to avoid a bond default. A ratings downgrade, the elimination of the tax-exemption for municipal bond interest, or an increase in mutual fund redemptions would threaten this access. However, all three of these events seem unlikely: Ratings Downgrade: Puerto Ricos ratings of Baa1/BBB are barely investment grade. A downgrade could force some selling and significantly limit demand. Fortunately, this scenario is unlikely in the near-term insofar as rating agencies generally give struggling issuers time to implement planned reforms. Elimination of tax-exemption: Federal tax exemption has supported retail demand for Puerto Ricos bonds, which are exempt at the local, state, and federal level. Without this triple tax-exemption, Puerto Ricos cost of borrowing would rise, as would the risk of a failed bond sale. Fortunately, federal lawmakers seem aware of Puerto Ricos dependence on triple-taxfree bonds, 34 and are unlikely to invite a default by pulling the subsidies for its debt Mutual Fund Redemptions: Many state-specific mutual funds are large buyers of Puerto Rico bonds, and they have supported the market for Puerto Ricos debt quite well. Strong mutual fund inflows in recent years have given these funds the capacity to do so. However, when interest rates begin to rise, these funds may enter a prolonged period of redemptions and their capacity to keep buying Puerto Rico bonds may diminish. If those redemptions coincide with further deterioration in Puerto Ricos credit quality, mutual funds could become sellers rather than buyers. A debt crisis in Puerto Rico might also ensue as a result of federal government austerity measures. Cuts to Puerto Ricos transfer payments and the end of favorable corporate tax treatment could significantly impact the islands credit profile. However, we believe the negative effects of these austerity policies are unlikely to materialize in the near future. Federal government cuts to Puerto Ricos transfer payments. Puerto Ricos citizenry depends heavily on federal government transfer payments, including those for food stamps, Medicaid, and social security. However, the federal government is unlikely to cut these programs independent of a wholesale reform, and there are only modest savings to be generated by reducing payments to Puerto Ricos residents. Job losses associated with the end of the preferential corporate tax treatment. Congress ended the Section 936 preferential tax treatment

Market Impact of a Default & New legal Precedents

If the Commonwealths financial reforms prove insufficient to correct its financial imbalances or the above-mentioned trigger events become more plausible, a Puerto Rico bond default will become more likely. This would have a significant impact on the municipal market and might result in legal precedents of interest to municipal investors.

Immediate Market Impact of Default

The municipal market would likely react strongly and negatively to such a default. The market remains largely dependent on retail demand, and Puerto Ricos debt is held widely by municipal bond mutual funds. Also, bond insurers are heavily exposed to the island. The retail investors who comprise the bulk of demand for municipal bonds would likely be frightened by a Puerto Rico default. Such a default would invite disturbing but inaccurate headlines that Puerto Ricos predicament presages U.S. state defaults. Investor skittishness could cause the market to underperform. Credit spreads would likely widen and liquidity might suffer. A default would also directly pressure municipal bond mutual funds. Puerto Ricos $60 billion in debt is held widely across these funds, 35 and a default would decrease their net asset values and share prices, inducing additional market outflows. A Puerto Rico default might also place further strain municipal bond insurers. Nearly 28% of the Commonwealths public debt is insured. 36 To our knowledge, every major insurer has significant exposure to Puerto Rico. 37

New legal Precedents

A Puerto Rico default might result in new legal precedents. These include (a) how to restructure a federal territory, (b) whether bondholders can really enforce contract rights against states, (c) whether certain tax secured bonds dilute security for general obligation bondholders, and (d) the extent to which sovereign immunity is a viable defense for a states non-payment of debt. Because it is a federal territory, there is significant uncertainty surrounding how Puerto Rico might restructure its debt. The Commonwealth is not a municipality, so it cannot adjust its debts through Chapter 9 of the bankruptcy code. 38 It is also not a sovereign state, so it may have limited flexibility to renegotiate debt contracts. Instead, it is possible that Congress would compel Puerto Rico to adopt restructuring terms to its liking via the Constitutions Territorial Clause. 39 Some sort of Congressional receivership might prove the best option,40 but it is unclear how this would work. A Puerto Rico default might shed light on the extent to which bondholders can enforce their contract rights against a state. Puerto Ricos bondholders have

SPECIAl CoMMENTARY, March, 2012

a first lien on Commonwealth resources. However, math and politics make it unlikely that bondholders will be paid, in full, if the Commonwealth cannot both meet debt service payments and secure the public health, safety, and welfare.41 A ruling validating Puerto Ricos ability to disregard its first lien pledge could conceivably weaken bondholder protections outlined in other states constitutions. Conversely, a ruling upholding Puerto Ricos first lien pledge might strengthen bondholder security. A default might also clarify when, if ever, tax secured bonds dilute security for general obligation bondholders. The Commonwealths COFINA bonds are backed by a new sales tax levy that arguably diverts revenue away from general obligation bondholders.42 It is unclear if Puerto Rico can segregate these sales taxes to the detriment of general obligation bondholders security.43 A ruling that upholds Puerto Ricos right to segregate these taxes might induce more tax secured financing by U.S. states and reduce security for some general obligation bonds. Another question is whether Puerto Rico can defend itself against a suit for nonpayment of debt by employing a sovereign immunity defense. The State of New Jersey successfully defeated a union-led lawsuit on sovereign immunity grounds earlier this year.44 Puerto Rico has sovereign immunity rights,45 and it is possible (albeit unlikely) that the Commonwealth has retained these rights with respect to bonds. 46
See Sam Garett, Political Status of Puerto Rico: Options for Congress, Congressional Research Service, June 7, 2011. For a listing of Puerto Ricos component units, see the Commonwealths FY 2010 Comprehensive Annual Financial Report, pp. 66-74. 3 Puerto Rico would likely seek federal help if the Commonwealth defaulted. Federal involvement would necessitate a debate regarding the islands legal status. Some Americans might support Puerto Rican statehood and a financial bailout in exchange for fiscal reforms. Others might seek to sever political ties with the island, altogether. 4 See Fox News Latino, Puerto Rico Primary Gives a Push to Luis Fortunos Statehood Bid, March 19, 2012. Available at: http://latino.foxnews.com/latino/news/2012/03/19/puerto-rico-primary-gives-push-to-luis-fortunosstatehood-bid/ 5 See Trends and Developments in the Economy of Puerto Rico, Federal Reserve Bank of New York, Current Issues, Vol. 14, No. 2 (March 2008) 6 Interest paid on Puerto Rico bonds is not taxed by federal, state, or local governments. This leads to a low cost-of-capital for the island nation. 7 Prior to 2006, foreign corporations operating in Puerto Rico could claim a large tax credit under section 936 of the federal tax code. Known as the possession tax credit, the favorable tax treatment drew many chemical and pharmaceutical manufacturers to the island. According to the Federal Reserve Bank of New York, more than 4% of the islands private sector workers are employed in the pharmaceutical industry. This is more than 10 times the mainland average. See Trends and Developments in the Economy of Puerto Rico, Federal Reserve Bank of New York, Current Issues, Vol. 14, No. 2 (March 2008). 8 Transfer payments include those for social security and food stamps, among others. They are a significant part of Puerto Ricos economy. In 2009, 32% of the federal governments food stamp payments went to Puerto Rico. The island nation represents less than 1.3% of the U.S. population. 9 See 2006 Center for the New Economy report. Available at: http://www.grupocne.org/information_bank/ FLMM.pdf 10 This compares to 45% in the U.S. See: United States Bureau of Labor Statistics and Puerto Rico Department of Labor and Human Resources. Data available at: http://www.grupocne.org/information_bank/FLMM.pdf. 11 See 2006 Center for the New Economy report (March 2007). Available at: http://www.grupocne.org/ information_bank/FLMM.pdf. See slides 24 - 26. 12 See UBS Wealth Management Research, Municipal Report Commonwealth of Puerto Rico (January 11, 2012). See also: March 7, 2012 Official Statement for Commonwealth of Puerto Rico Public Improvement Refunding Bonds, Series 2012A, p. 4. Available at: http://emma.msrb.org/EP611148-EP478117-EP878493.pdf. The Commonwealth reports a lower FY 2012 deficit in the Official Statement because it excludes $685 million in refinanced debt service from its calculation. Most financial analysts would include the refinanced amount. See the UBS report and the Center for the New Economy website note, available at: http://grupocne.org/ cneblog/?p=831. 13 See Government Development Bank (GDB) Statistical Appendix of the Economic Report for the Governor and Legislative Assembly, Tables 3 and 29, available at: http://www.gdbpr.com/economy/statistical-appendix.html. 14 See Government Development Bank (GDB) Statistical Appendix of the Economic Report for the Governor and Legislative Assembly, Tables 3 and 29, available at: http://www.gdbpr.com/economy/statistical-appendix.html. See also March 7, 2012 Official Statement for Commonwealth of Puerto Rico Public Improvement Refunding Bonds, Series 2012A, p. I-56. Available at: http://emma.msrb.org/EP611148-EP478117-EP878493.pdf 15 Figure includes debt guaranteed by the Commonwealth and revenue bonds. See: Puerto Ricos FY 2010 Comprehensive Annual Financial Report, pp.137. 16 Most Puerto Rico bonds are held by mainland U.S. residents who are attracted to the islands triple-tax-free interest payments. Affluent residents of New York City often find the bonds particularly attractive because they face high marginal city, state, and federal income tax rates. 17 See Government Development Bank data and official statements from latest bond offerings. 18 For example, in February 2012, the Governor of Puerto Rico pointed to a modestly improved economic report as evidence that the islands recession was over. His statement ignored the fact that economic growth, as measured by the Government Development Bank, actually declined on a month-over-month basis. See Puerto Ricos recession is over, Governor says, Feb. 21, 2012, Reuters. Available at: http://www.reuters.com/ article/2012/02/21/puertorico-economy-idUSL2E8DLFKI20120221. The GDBs January 30, 2012 Economic Indicators report showed that the Commonwealths Economic Activity Index finished at 128.2 in November 2011 compared to the December 2011 figure of 127.7. See: http://www.gdbpr.com/economy/GDB-EconomicActivity-Index.html 19 At the end of fiscal year 2010, the Commonwealths public corporations owed $607 million to the primary government, and $3.6 billion to each other. During that year, the primary government expensed $2.7 billion in payments to the Commonwealths major public corporations. The Commonwealths primary government budget is roughly $20.7 billion. One expert, Sergio Marxauch, has noted that: the Byzantine structure of our government, with its manifold executive departments, has generated a complete lack of accountability, oversight, and transparency in government operations See: 2006 Center for the New Economy report. Available at: http://www.grupocne.org/information_bank/FLMM.pdf 20 See Puerto Ricos FY 2010 Comprehensive Annual Financial Report, pp. 120 125. 21 See Municipal Market Advisors, Weekly Outlook, April 2, 2012. 22 In FY 2010, $2.3 billion of the GDBs public sector loans were delinquent by 90 days or more, an amount equal to 27% of the GDBs loans receivable. This figure is up from $510 million in FY 2006. Delayed loan collection is one reason the banks net interest margins (interest earned on lending less interest paid on borrowings) are low. See the following sources: Official Statement, Government Development Bank for Puerto Rico, Senior Notes, Series 2011A and 2011B, December 21, 2011, pp. 10 and 25; Official Statement, Government Development Bank for Puerto Rico, Senior Notes, Series 2006A, February 8, 2006, p. 29; and Standard & Poors January 27, 2011 rating opinion for The Government Development Bank for Puerto Rico. 23 Instead, the Commissioner of Financial Institutions of Puerto Rico performs audit examinations of the bank every 18 months. See Standard & Poors January 27, 2011 rating opinion for Government Development Bank for Puerto Rico. 24 The bank has fiscal oversight agreements with the Highways and Transportation Authority, the Puerto Rico Aqueduct and Sewer Authority (PRASA), the Electric Power Authority, the Ports Authority, the Puerto Rico medical Services Administration, and the Puerto Rico Health Insurance Administration. It also has a fiscal oversight-type agreement with the University of Puerto Rico. See: Official Statement, Government Development Bank for Puerto Rico, Senior Notes, Series 2011A and 2011B, December 21, 2011. 25 See Puerto Ricos FY 2010 Comprehensive Annual Financial Report, pp. 196. 26 See March 7, 2012 Official Statement for Commonwealth of Puerto Rico Public Improvement Refunding Bonds, Series 2012A, p. I-56. Available at: http://emma.msrb.org/EP611148-EP478117-EP878493.pdf. However, note that Moodys reports suggest a slightly brighter picture. Moodys believes recent reforms have extended the life of Puerto Ricos pension funds by roughly six years. See Moodys Investors Service, Issuer Comment, Key Drivers of Puerto Ricos Downgrade to Baa1, August 10, 2011. At that time, Moodys expected pension reforms to extend the life of the ERS from 2019 to 2025. 27 Acts 7, 154, 171. 28 Act 161.
1 2

Conclusion
Although the threat is not imminent and the risk remains slim, Breckinridge believes the possibility of a default by Puerto Rico is sufficient to warrant the attention of municipal investors. A Puerto Rico default would have negative market implications. High grade investors should understand the Commonwealths fiscal problems because a default might trigger mutual fund redemptions and bouts of illiquidity. However, Puerto Ricos debt situation is unique and unparalleled in the United States. A debt crisis in Puerto Rico will have limited impact if any on the extremely remote likelihood of a U.S. state default. We end with a graph that illustrates just how different Puerto Rico is compared a distressed U.S. state: Illinois. Illinois compares very favorably even though it faces several years of large structural deficits and large pension and retiree healthcare liabilities.

* includes revenue debt and state guarantees Gsp = Gross state product source: U.s. Bureau of economic analysis, puerto rico planning Board, and comprehensive annual Financial reports, illinois and puerto rico, Fy 2010.

Puerto Ricos Economic and Fiscal Condition Compares Poorly Even to Illinois

Illinois population (millions) 13 % of population employed 47% Gsp per capita $50,938 Bonded Debt*/Gsp 4% Unfunded pension & retiree Healthcare 16% Debt/Gsp cumulative General Fund Deficit (Fy 10) -16% Federal aid as % of Budget 30%

Puerto Rico 3 35% $15,900 90% 44% -9% 32%

SPECIAl CoMMENTARY, March, 2012

Act 7. Act 29. 31 Acts 114, 116. 32 See Government Development Bank data. Available at: http://www.gdbpr.com/economy/GDB-EconomicActivity-Index.html 33 The Commonwealth received a lump sum payment of $1 billion as part of a toll road leasing agreement in September 2011. See March 7, 2012 Official Statement for Commonwealth of Puerto Rico Public Improvement Refunding Bonds, Series 2012A, p. I-31. Available at: http://emma.msrb.org/EP611148-EP478117-EP878493.pdf 34 See Report by the Joint Committee on Taxation, An Overview of the Special Tax Rules Related to Puerto Rico and An Analysis of the Tax and Economic Policy Implications of Recent Legislative Options, June 23, 2006. Available at: http://www.jct.gov/publications.html?func=startdown&id=1496. 35 Mutual funds own Puerto Rico because it comprises 4% of the Barclays municipal market index, and 50% of the BBB portion of that index. Most funds are benchmarked to the performance of these indexes. See: Barclays Municipal bond Index, March 27, 2012. Note also that the $60 billion figure is from the Government Development Bank (GDB) Statistical Appendix of the Economic Report for the Governor and Legislative Assembly, Table 29, available at: http://www.gdbpr.com/economy/statistical-appendix.html 36 Breckinridge analysis of Bloomberg data, 3/23/2012. 37 For example, Assured Guaranty has at least $4.8 billion in exposure to Puerto Rico, and the islands debt also comprises six of the top 10 exposures for Financial Guarantee Insurance Company (FGIC). See: Assured and FGICs statutory statements, December 2011. 38 See 11 USC 101(52). 39 Congress is given broad powers under the Territorial Clause of the U.S. Constitution. See: Sergio Marxauch, Municipal Fiscal Crises in the United States: Lessons and Policy Recommendations for Puerto Rico, Center for the New Economy, April 28, 2006, p. 15 40 See Sergio Marxauch, Municipal Fiscal Crises in the United States: Lessons and Policy Recommendations for Puerto Rico, Center for the New Economy, April 28, 2006, p. 15. 41 Section 8, Article VI of the Constitution of Puerto Rico gives general obligation bondholders a first claim on all available Commonwealth resources. However, math and the threat of public disorder have a way of bending seemingly ironclad clauses in state constitutions. For example, the Commonwealth might argue that its debts are merely those of a federal territory and that bondholders have limited legal recourse against a federal government sovereign including its territories. This would be a novel approach, but it might work in conjunction with a federal bailout. Importantly, Puerto Rico has already demonstrated a willingness to restructure contracts to ameliorate its financial situation. Last year, the Commonwealth successfully abrogated a collective bargaining agreement on the grounds that it was reasonable and necessary to tear-up the contract. See: United Automobile, Aerospace, Agricultural Implement Workers of America International Union, et al. v. Luis Fortuno, et al., 633 F. 3d 37 (January 27, 2011) 42 The Commonwealths most senior debt obligations are its general obligation bonds and its COFINA bonds. COFINA bonds are sales tax backed bonds that are, at least theoretically, insulated from general fund obligations. Puerto Ricos general obligation bondholders have long been secured by the Commonwealths available resources, including its taxing power. But when COFINA bonds were created, lawmakers deemed the sales taxes that backed them as unavailable resources. 43 Prior courts have ruled that local governments may carve out specific available revenues to the detriment of pre-existing general obligation bondholders. In fact, dedicated tax bonds are routinely issued across the country. However, Puerto Ricos COFINA bonds were issued in a time of distress, arguably to the detriment of general obligation bondholders. Also, the only case we know of in which a carve-out was upheld against a general obligation bondholder involved a tax increment financing district. In that case, the pledged revenue was never made available for general fund operations. COFINA bonds are supported by a sales tax, half of which flows back to the general fund. This fact may have implications for the strength of the COFINA bonds dedicated tax pledge. The tax increment financing case is: Wolper v. City Council of City of Charleston, 287 S.C. 209, (1985). 44 See N.J. Educ. Assn v. New Jersey, 2012 U.S. Dist. LEXIS 28683. 45 See Porto Rico v. Ramos, 232 U.S. 627 (1914). 46 Puerto Ricos constitution certainly implies that the Commonwealth has waived its sovereign immunity defense. However, the language in Puerto Ricos Constitution is more vague than language used by U.S. states. Puerto Ricos Constitution provides in Article VI, Section 2: The Secretary of the Treasury may be required to apply the available revenues including surplus to the payment of interest on the public debt and the amortization thereof in any case provided for by Section 8 of this Article VI at the suit of any holder of bonds or notes issued in evidence thereof (emphasis added). It is unclear from this language whether Puerto Ricos Constitution refers to suits in Puerto Rican courts or in Federal courts. The U.S. Supreme Court has held that sovereign immunity rights are waived only when the waiver is stated by the most express language or by such overwhelming implication from the text as will leave no room for any other reasonable construction. See: In re Creative Goldsmiths of Washington, D.C., Inc., 119 F. 3d 1140 (4th Cir. 1997), at 1147. In other bond indentures, we often see a clearer statement of intent that includes words like sovereign immunity, waiver, or governmental immunity, among others.
29 30

DISCLAIMER: The material in this document is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Nothing in this document should be construed or relied upon as legal or financial advice. All investments involve risk including loss of principal. An investor should consult with an investment professional before making any investment decisions.