WASMER, SCHROEDER & COMPANY

I N V E S T M E N T A DV I S O R S

November

PuertoRico: GreeceoftheWest?

2011

PUERTORICO:GREECEOFTHEWEST?

PUERTORICO:THEGREECEOFTHEWEST?
Overthepastyear,municipalcreditqualityhascome underfirewithanumberofpeople,mostnotably MeredithWhitney,callingforlargeincreasesin municipalbonddefaults.As2011hasmarchedon,we haveactuallyseenfewerdefaultsthan2010with numbersnotclosetothehundredsofbillionsthat Whitneyforetoldina60Minutesnewsreport.The questionremainsthough,Willweseeanuptickindefaultsforvulnerablecredits?Aswehavearticulated innumerouspiecesoverthepastyear,Wasmer,Schroeder&Companyhasnotbelievedtherewouldbea rashofdefaultsinthemunicipalsectorin2011andwemaintainthatoutlook.Wedobelieve,however,that troubleispotentiallyonthehorizonforonewidelyownedcreditinparticular,anditssimilaritiestomanyof theweakerEuropeannationsareworthnoting.ThiscreditistheCommonwealthofPuertoRico.Whilewe donotbelievethatdefaultisimminent,thepotentialdoesexistthatPuertoRicodigsafinancialholesodeep thatthereremainsnowaytogetout.WhileourseparatelymanagedaccountshavenoexposuretoPuerto Ricogeneralobligation(GO)bondsoritspubliccorporations(otherthanthosewhichareprerefundedor escrowedinUSGovernmentsecurities),wedobelievethatthewidespreadownershipofPuertoRicos bonds,thelargeamountofdebtoutstandinganditshighprofilestatuscouldhavefarreachingimplications forthemunicipalmarketasawholeifPuertoRicowereexposedtoanyseverefiscalstress.

HISTORY
PuertoRico,meaningrichport,wasfirstclaimedbyChristopherColumbusforSpainin1493andforover 400yearswasacolony/territoryofSpain.In1898,duringtheSpanishAmericanWar,PuertoRicowas invadedbytheUSandwascededtotheUSundertheTreatyofParis.In1917PuertoRicansweremadeUS citizensandin1947theUSgrantedPuertoRicothepowertoelectitsowngovernor.PuertoRicoisofficially anunincorporatedterritoryoftheUS.ThismeansthatUSFederallawappliestoPuertoRicodespite havingnovotingrepresentationinCongress.ThePuertoRicanconstitutiondeclaresthattheyarea CommonwealthoftheUS.ThisrequirescitizenstopayFederaltaxesincludingSocialSecurityandMedicare taxes,aswellasimport/exporttaxesandfederalcommoditytaxes.ResidentsofPuertoRicoarenot residentsofastateortheDistrictofColumbiaandthereforearenotqualifiedtovoteinFederalelections1. AnothermajordifferencebetweenPuertoRicoandthestatesisthefactthatthepopulacemayvoteto dissolvetheirCommonwealthstatus,andunlikeUSstates,thisvotewouldnotrequiretheapprovaloftheUS Congressorstateratificationtodoso.Whilearemoterisk,itisoneuniquetoPuertoRicoandbears considerationbybondholders.Additionally,andmostimportantlyformunicipalbondinvestors,interest incomeproducedbyPuertoRicosbondissuesistaxexemptattheFederal,stateandlocallevelinanystate intheUS,thusmakingthemdesirableforthoselivinginhightaxlocales.

www.topuertorico.org
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PUERTORICO:GREECEOFTHEWEST?

CURRENTECONOMY
PuertoRicoseconomyislargelydominatedbythegovernmentandtourismwithmanufacturingandtrade accountingforsignificantportionsoftheeconomyaswell.PuertoRicohashistoricallybeenapoorterritory inrelationtoUSstates;over44%2(comparedto15%intheUS3)ofthepopulationlivesbelowthefederal povertyline.Thisrampantpovertyhasalsocontributedtoanextremelyhighcrimeratewith22.54murders per100,000people,worsethananyUSstate.PuertoRicowasexperiencinganeconomicslowdowneven beforethe2008financialcrisisoccurredandtheireconomicwoeswereexacerbatedbytheweakdemand comingfromtheUSandtherestoftheworldintheaftermathof2008.Priortothecurrentgovernors tenure,fiscaldisciplinewasoftenignoredandlargebudgetdeficitswerethenorm,risingto$3.3billion5in 2009(2001wasthelastyearwithabudgetsurplus).Thevastmajorityofdeficitswerefinancedwith borrowingasopposedtoaneffortofcuttingcosts,especiallywiththecreationofCOFINAbonds6which arebackedbysalestaxrevenuesandeffectivelysubordinateGObondholdersthroughthisnewstructure.As thetablebelowshows,debthasconsistentlygrownoverthepastseveralyearsbyutilizingnonGOavenues toraisecapital.Whilethishasallowedlowerborrowingcosts,thepledgingofrevenuestreamsconstrains budgetflexibilityinthefuture.
ITEM CentralGovernmentTotal Constitutional TRANSsandTRABs Extraconstitutional COFINA(net) PublicCorporationsTotal PRASA PREPA PRHTA PRRBA PRIFA PRPA OtherandDebtswithDGBandPrivate Municipalities DebtnotsupportedbyGeneralFund DECEMBER08 14,228 9,006 2,500 2,721 6,306 26,596 2,827 6,031 6,344 3,124 1,853 59 6,358 2,838 6,489 DECEMBER09 13,208 9,511 900 2,797 11,544 27,358 3,144 5,858 6,240 3,300 1,828 56 6,932 3,139 5,407 DECEMBER10 12,782 9,193 900 2,689 14,218 28,195 3,473 7,781 6,120 3,324 1,798 46 5,653 3,331 5,358 $DIFFERENCE(20102008) (1,446) 187 (1,600) (32) 7,912 1,599 646 1,750 (224) 200 (55) (13) (705) 493 (1,131)

Debt,GrandTotal

56,455

60,656

63,884

7,429

Source:GovernmentDevelopmentBankforPuertoRico

www.topuertorico.org USCensusBureau 4 AssociatedPress 5 OfficeofManagementandBudget 6 COFINAistheSpanishacronymforthePuertoRicoSalesTaxFinancingCorporation,anindependentinstrumentality oftheGovernmentofPuertoRicocreatedin2006

3 2

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PUERTORICO:GREECEOFTHEWEST?
TheeconomyofPuertoRicoremainsweakandadropinGross DomesticProduct(GDP)isexpectedforthecurrentfiscalyear. Unemployment,despitefallingfromitshighs,isstillatacrippling 15.4%asofSeptember2011andthelaborparticipationrateof40% isfarbelowtheUSaverageof64%.Thevalueofconstruction permitshasfallenapproximately23%yearoveryear,althoughtrade andtourismhavereboundedwithgrowthof5.2%and17.8%year overyear,respectively.Mosttroubling,andofgreatimportanceto thegovernmentsfinances,aretheunfundedpensionliabilitiesof PuertoRico.Forfiscalyear2010,thetwolargestgovernment pensionplans,PublicEmployeesandTeachers,werefundedat8.5% and23.9%,respectively;whereastheaverageUSstatesfunding ratiois75%.Thegovernmenthasputplansinplacetohelpeasethis burdenbyconvertingtoadefinedcontributionplan,increasingthe employercontributionrateeveryyearforthenexttenyearsand reducinggovernmentpayrollnumbers.Despitethesechanges,itis stillestimatedthatthepensionfundswillbecomeinsolventasearly as2019.Outstandingpublicdebthasincreasedby9%peryearover thepasttenyears,fargreaterthantheCommonwealthsrateof growth.Debtservicecostsremainamanageable6.5%of expendituresbutmuchoftheCommonwealthsdebtisbackend loaded,puttingagreaterburdenonfuturegenerations.7,8,9 Onthepositiveside,GovernorLuis Fortuohasmadeitagoaltogetthe Commonwealthsfiscalhouseinorder.He hasimplementedanumberofpermanent andtemporarytaxincreases.Hehasalso cutgovernmentexpensesandpayrollover thepasttwoyearsby19%and16%, respectively10.Ahiringfreezeacrossall agencieshasbeenimplementedasthe governmentpayrollofPuertoRicois notoriouslybloatedandaccountsfor approximately30%ofPuertoRicosentire payroll.Whilethegovernorexpectsto achieveabalancedbudgetin2013and createarainydayfundby2014,slower thanexpectedgrowthand/orpolitical considerations(includingthefactthat GovernorFortuoistrailinghismore liberalchallengerinrecentpolls),could
7 8

GDPGROWTH FORECSTS,2011 FastestTen

0% Qatar Ghana Mongolia Eritrea Ethiopia China India Usbekistan TimorLeste Laos 3% 6% 9% 12% 15% 18%

SlowestTen
5% 4% 3% 2% 1% Spain Bahamas Iceland Italy Venezuela Ireland Barbados Portugal Greece PuertoRico 0% 1%

Source:TheEconomist

PAYROLL EMPLOYMENT
Source:GovernmentDevelopmentBankforPuertoRico,asof11/9/2011

4%

5%

4% 29%
Government Contruction&Mining Trade Finance,Insurance&RealEstate

33% 3% 16% 5%

Services Manufacturing DurableGoods Manufacturing NondurableGoods Other

OfficeofManagementandBudget BureauofLaborStatistics 9 GovernmentDevelopmentBankforPuertoRico 10 OfficeofManagementandBudget

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PUERTORICO:GREECEOFTHEWEST?
derailsomeofthefiscalconservatismdemonstratedbythecurrentadministration.Debtburden continuestoriseanduntilthisbeginstodroportheeconomybeginstogrowfasterthantheriseindebt, theCommonwealthofPuertoRicoisheadingforapossiblefiscaltippingpoint.

COMPARISONTOTHEPORTUGAL,IRELAND,ITALY,GREECE,SPAIN(PIIGS)
While2008wasallabouttheproblemsintheUSanditsbankingsystem,2011hasbeencharacterizedbythe EuropeanUnion(EU)anditsbanks.WhiletheEUstruggleswithhowtocreateanorderlydefaultinGreece andinvestorsremainskepticalastowhetherotherEUnationssuchasItalyandSpainwillbeabletoescape massivedebtrepudiation,weseesimilaritiesbetweentheseweakEUcountriesandPuertoRico.Asthetable belowillustrates,PuertoRicoseconomicanddebtstatisticsarefarmoregrimthanthemostleveragedstates intheUSbutareapproachinglevelsseeninthePIIGS.

Debtto DebtPer Unemployment PerCapita Debtto GDP/GSP Capita Rate(%) Income IncomeRatio PuertoRico* 31% $7,837 15.40% $13,675 57.3% Massachusetts 8% $4,606 7.30% $51,302 9.0% Hawaii 8% $3,996 6.40% $41,661 9.6% Connecticut 8% $4,859 8.90% $54,877 8.8% NewJersey 7% $3,669 9.20% $51,167 7.2% Greece 166% $34,103 12.60% $27,360 124.6% Portugal 106% $16,402 11.00% $24,710 66.4% Ireland 109% $35,122 13.70% $32,740 107.3% Italy 121% $38,025 8.40% $31,090 122.3% Spain 67% $17,539 20.10% $31,550 55.6% *DoesnotincludePublicCorporationswhichhaveanadditional$28blnindebt Sources:DeutscheBank,StateofConnecticutGeneralAssembly,BureauofLaborStatistics,BureauofBusiness& EconomicResearchattheUniversityofNewMexico,EuropeanCommission,TheEconomist,WorldBank

Structurally,PuertoRicohasmanysimilaritiestotheseEuropeannationsincluding,butnotlimitedto,a bloatedgovernmentworkforce,largeunfundedpensions,extremelyhighunemploymentrates,largedebt levelsasapercentageofincomeorGDP,andweaktaxcollections.Whilenoneofthesemetricsisatthe pointtolimitPuertoRicosabilitytoborrowinthefinancialmarkets,thepossibilityexiststhattheircurrent trajectorycouldleadtoacrisisofEuropeanproportions.Continuedgovernmentjobcutswhicharenot offsetbyprivatepayrollgrowthandreducedbenefitscouldleadtounrestsimilartowhathasbeenseenin Europe.ProceedsofPuertoRicosborrowingarebeingusedtopaypreviousdebtsasopposedtobuilding infrastructureorcreatingeconomicgrowth.Ofthecloseto$8billioninCOFINAborrowingsin200910,94% wasutilizedtopayexistingdebtsanddealwithdeficits.MunicipalborrowinginPuertoRicoiscloseto$64 billionasof2010.WhilenotallisdirectlytiedtothegovernmentofPuertoRico,thevastmajorityofthis debthassomeconnection.Basedonthismetric,debtpercapitaisawhopping$17,265whichismorethan thatofPortugal,closetothatofSpain,andwellabovePuertoRicoslowpercapitaincome11. Despitehavingafiscallyconservativegovernor,thehistoryofPuertoRicoisonelitteredwithcronyismand irresponsiblefiscalchoices.Furthermore,PuertoRicoremainsanextremelyimpoverishedterritoryand growthprospectsremaindim.WhilethesimilaritiesbetweenthePIIGSandPuertoRicoareglaring,itis importanttonotethatimportantdifferencesdoexist,mostnotablythefactthatthebankingsystemin PuertoRicoisnotthreatenedatthecurrenttime.ManyUSbankshaveoperationsinPuertoRicoandthe
11

GovernmentDevelopmentBankforPuertoRico
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PUERTORICO:GREECEOFTHEWEST?
GovernmentDevelopmentBankcontinuestoexpanditsbalancesheetandmanageliabilitiesreasonablywell. Also,atleastcurrently,thereisnodesireamonginvestorstoshedPuertoRicodebtandtheirupcomingdebt maturitiesremainmanageablewithouttheballoontypepaymentsweseeinmanyEuropeannationsand someareasofthecorporatebondmarket.Stillthetrajectoryremainstroubling;ifPuertoRicosfiscal problemsarenotaggressivelydealtwithbytheendofthecurrentdecade,themunicipalmarketcouldbe facedwithasignificantcredithurdle.

CONCLUSION
ManyinvestorsarecomfortableholdingPuertoRicodebtdespitetheirlowratings(whicharemostlyinthe BBBandAcategories)becauseofthebeliefthatiftheygotintoseverefiscaltroubletheUSCongressmay bailthemout.AsaCommonwealththeyhavenoaccesstomunicipalbankruptcyandthereisnoimplicitor explicitguaranteeofthedebtbytheUSgovernment.DoesthismeanthatCongresswouldnotcometotheir aid?Notnecessarily,butinanincreasinglycontentiouspoliticalenvironmentwithfiscalconservatism runningrampant,theoddsofabailoutseemfarlesslikelythanafewyearsago.Additionally,aswehave seenwithJeffersonCounty,ALandHarrisburg,PA,localpoliticscanplayanimportantroleinthewillingness ofgovernmentstopay. PuertoRicosgrowingdebtburdenandpensionliabilitiesmaybecomesolargethatnoactionbesides restructuringcanbetakentoresolvetheirfiscalissues.WehopethatPuertoRicocontinuesonitspathto fiscalresponsibilitybutarekeenlyawareoftherisks,botheconomicallyandpolitically,toPuertoRicobonds andtheircreditratingsifthingsdonotimprovemateriallyandquickly.

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