Puerto Rico Recovery Act

On June 25th, Governor Padilla laid out a proposal to allow some of Puerto Rico's public corporations to enter into a bankruptcy-like process. The previous day, Federal Reserve Bank of New York President William Dudley had noted that, "Persistent deficits in the Commonwealth’s fiscal accounts as well as mounting deficits in the operation of the several major public corporations have substantially raised the Island’s overall level of public debt and led to serious concerns about whether the Island’s fiscal position is sustainable." Public corporations themselves account for roughly 40% of the island's outstanding debt.

Many public corporations and governmental entities are not eligible to use the Recovery Act, specifically: the Commonwealth, the seventy-eight municipalities of the Commonwealth, the Government Development Bank (GDB), the Children's Trust, the Employees Retirement System, the Judiciary Requirement System, the Municipal Finance Agency, the Municipal Finance Corporation, the Puerto Rico Industrial Development Company, the Puerto Rico Industrial, Tourist, Educational, Medical and Environmental Control Facilities Financing Authority, the Puerto Rico Infrastructure Financing Authority, Puerto Rico Sales Tax Financing Corporation, the Puerto Rico System of Annuities and Pensions for Teachers, and the University of Puerto Rico. The exclusion of coverage for GO bonds and GDB issuance was communicated front and center in an attempt to avoid market turmoil. 

Treasury Secretary Melba Acosta clarified that, "The main purpose of the law is to protect the interests of the people of Puerto Rico and to ensure that the gap in federal law does not jeopardize essential public services. The Recovery Act also protects Puerto Rico's GO debt by giving public corporations the opportunity to address their financial challenges once and for all and thereby no longer depend on the General Fund," adding that, "Over the past year, the GDB has reiterated that the public debt of the Commonwealth should not be seen as a sum of debts to a single debtor, but rather as individual loans supported by various sources of revenues and income."

The passed legislation allows two routes for restructuring: Chapter 2, which encourages the debtor and creditors to reach an agreement without judicial intervention, and Chapter 3, with court oversight for cases in which negotiation has stalled. 

Three notable public corporations which will have these options are the Puerto Rico Electric Power Authority (PREPA), Puerto Rico Aqueduct & Sewer Authority (PRASA), and Puerto Rico Highways & Transportation Authority (PRHTA). PREPA had about $8.9 billion in debt according to its most recent financial statements, while PRASA had about $5.2 billion, and PRHTA had about $4.7 billion, for a total of approximately $19 billion. 

The market has reacted negatively to the announcement of the new legislation, with Puerto Rico's most recent debt issuance trading at yields of 9.3% when the Act was announced on June 25, compared with 8.6% at issuance in March. On Monday, June 30, PREPA bonds traded at record high yields of just less than 15%, while the yield on Puerto Rico GO Bonds fell back to around 9%, perhaps reflecting a more measured interpretation of the legislation.

S&P put Puerto Rico on CreditWatch with a negative outlook on the day the legislation was proposed, and dropped the rating on PREPA bonds to BB two days later. PRASA has been placed under review by S&P, as has PRHTA. Fitch and Moody's made similar downgrades to PREPA debt, with Moody's taking the additional step of downgrading the island itself, from Ba2 to B2, a three-notch drop. The rating agencies had previously praised Puerto Rico for its commitment to taking actions needed to support debt, and all three are now reevaluating that stance in light of the new law. Moody's, which downgraded nearly everything Puerto Rico related, stated that "[The Recovery Act] signals a depleted capacity for revenue increases and austerity measures, and a new preference for shifting fiscal pressures to creditors, which, in our view, has implications for all of Puerto Rico’s debt, including that of the central government."

In response to the announced legislation, U.S.-based mutual funds holding approximately $1.7 billion in Puerto Rico debt have filed a lawsuit asking a federal judge to declare that the Act violates the U.S. Constitution. The case is being brought by Oppenheimer funds, whose Rochester series has high levels of exposure to Puerto Rico, as well as Franklin Funds. Both fund companies have exposure in excess of $800 million to PREPA bonds specifically, and high exposure to multiple other issuers within Puerto Rico. U.S. District Judge Jay A. Garcia-Gregory in San Juan today gave the island 21 days to respond to the lawsuit.

In a surprise response to the news, BTIG Equity Research downgraded MBIA Inc. from buy to neutral, based on the insurer’s exposure to Puerto Rico. MBIA insures approximately $1.5 billion in Puerto Rico debt, and news of the downgrade and its exposure sent shares down over 5%. Bond insurers suffered similar knock-on effects during the Credit Crisis, based on their exposure to mortgage-backed securities.

In just a few short days, emergency legislation enacted by Puerto Rico has had a resounding impact on many capital markets participants. We will continue to monitor the situation and bring you additional coverage as more details unfold.