July_2015 Puerto Rico Municipal Mkt Update

MUNICIPAL MARKET UPDATE July, 2015

Puerto Rico: An Extremely Fluid
Situation with Many Unknowns

Although we are not investors in Puerto Rico The Governor has asked Commonwealth officials to
municipals; the very size of its debt market ($72 produce a more detailed restructuring plan by August
billion) as well as the mounting financial and fiscal 30th.The uncertainties going forward are due to three
policy challenges the island faces today will have an major factors:
impact on the broader Municipal market. The
following overview sheds light on the more recent 1. The unique position that Puerto Rico occupies as
developments and puts in context the uncertainty of neither a sovereign country nor a state of the
Puerto Rico’s financial stability. United States. Legally, neither Puerto Rico nor its
agencies are currently eligible for Chapter Nine
Current Situation under the U.S. Bankruptcy Code; and, as a territory
Over the last year, Puerto Rico’s economic situation has of the U.S., it is not eligible to apply for assistance
deteriorated to the point that the Commonwealth’s from the IMF.
short term liquidity is in question. Revenues from tax
increases and service cuts have fallen short of optimistic 2. The size and variety of debt instruments that it and
projections and efforts to grow the economy have failed its agencies have issued. There is over $72 billion of
to reverse the continuing recession. Emigration off the public debt outstanding with 17 issuers and a wide
island continues, with younger adults the most likely to array of security structures. For example, the
leave. The current administration of Governor Alejandro Constitution of Puerto Rico prioritizes the payment
Garcia-Padilla, which took office in 2013, has gone from of general obligation debt service before all other
promising the timely repayment of all debt, to trying to expenditures, while other securities have liens on
facilitate the restructuring of agency debt, to finally sales taxes or utility revenue streams.
suggesting that all classes of debt, including general
obligations, might need to be restructured. It was feared 3. The number and divergent interests of the
that some of the debt service due on July 1st would not creditors with which it will have to negotiate.
be paid, specifically that of PREPA, the electric utility; but These include several bond insurers guaranteeing a
all was paid, although there was a continuation of variety of issues, mutual fund complexes that own
creditor forbearance in PREPA’s case. Positively, for the large amounts of the island’s debt, and hedge fund
general market, at this point there has been no and distressed asset investors who purchased
“contagion” and it would appear that much of the Puerto Rico paper at steep discounts. Additionally,
downside is already priced in. there are the direct holdings of thousands of retail
investors in brokerage accounts, including a
Recent Developments substantial amount of “on island” paper that is
On July 13th, the Commonwealth made a presentation owned by local retail investors.
to investors in NYC featuring Anne O. Krueger, who
reported on the conclusions of a report she co-authored The initial intent of the current administration when it
on Puerto Rico’s economic situation with two other saw its fiscal position deteriorating was to try to force
former IMF officials. She suggested that the only way restructuring of its agencies’ debt, while keeping its
forward was a comprehensive approach, including fiscal general obligations current. In this way it could at least
adjustment by the Commonwealth, structural and maintain that its highest credit did not default, and
institutional reforms both at the Commonwealth and remained a possible re-entry vehicle to the capital
Federal level, and, finally, debt restructuring. Few markets. As the island was not eligible for Chapter
specifics were given. Nine, the administration proposed, and the Puerto Rico
legislature passed, a restructuring law for government
agencies that mimicked the provisions of Chapter Nine.

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This law was declared unconstitutional by a judge in  As Puerto Rico’s liquidity declines, individual
Puerto Rico and the ruling has been subsequently credits miss debt payments and various creditors
upheld by a U.S. Court of Appeals. The island’s non- commence legal actions to compel the
voting representative in Congress then introduced a Commonwealth to honor the terms of its bond
bill that would allow Puerto Rico government agencies indentures. This could result in a very complex
to seek protection from creditors under Chapter Nine. legal situation where courts in different jurisdictions
While Democrats in Congress were generally positive, might be litigating multiple and overlapping claims.
the Republicans, who control both Houses, were cool It would resemble sovereign debt restructurings,
to the idea and so it remained in committee. At that like Argentina’s, which are usually contentious,
point, the Governor changed his tactics and declared multi-year long affairs.
the entirety of the debt unsustainable, suggesting that
perhaps the entire Commonwealth be allowed to file We expect that the Commonwealth will produce some
under Chapter Nine. This is where the situation stands plan by the end of August. Before that time it is
today. possible that some Puerto Rico credit may miss a debt
service payment. (It was reported on July 16th, that the
Next Steps Puerto Rico Public Finance Corp. failed to transfer cash
Going forward, there are a couple of broad directions a to a trustee to cover a $36.3 million debt service
restructuring can take: payment due to be paid on August 1st). We do not see
a Chapter Nine compromise proposal that would
 Puerto Rico negotiates a voluntary debt exchange, garner bipartisan support emerging from committee
outside of bankruptcy, with many of its creditors anytime soon. Puerto Rico will probably enter into
after proposing a comprehensive program of fiscal negotiations with its creditors under the threat of
and structural reforms. While this is the stated and litigation, while itself being able to threaten general or
preferred outcome of the Commonwealth, it seems specific payment moratoria. As long as the day- to- day
unlikely that this can be easily achieved given the functioning of the island is not seriously impaired, it is
divergent interests of major creditors and the unlikely that the Congress will be forced to act. If,
difficulty of obtaining a critical mass of them to however, there is a breakdown of essential services or
agree to any specific settlement. Hence the scenes of distress among the general population, the
Commonwealth’s support for the second possibility. pressure to do something will rise. Complicating the
situation will be the political posturing in the lead up to
 The Congress passes legislation allowing Puerto Rico the 2016 U.S. Presidential election.
and/or its agencies to qualify for Chapter Nine.
While this would provide a legal structure for Conclusion
restructuring negotiations, there is little impetus for All Puerto Rico issues remain highly speculative,
the Republican- controlled Congress to pass this in distressed credits that face likely restructurings of
the near future. There is also the question of uncertain severity and duration. The general market
whether Chapter Nine should apply to just the seems to have taken this in stride, and while fund
agencies or to the island as a whole. In addition, flows have been somewhat negative recently, YTD they
there have been calls, principally from are still positive. A large amount of outstanding debt
conservatives, for the Congress to appoint a has moved from traditional investors into
financial control board that would supersede the speculative/hedge fund accounts, with the remaining
elected government and oversee the restructuring mutual fund exposure concentrated in two fund
process. That provision would, of course, be complexes that have already had their holdings
opposed by the current Commonwealth marked to market. These factors should continue to
administration and probably by their Democratic insulate the larger investment grade municipal market
allies in Congress. whichever direction the pending workout takes.

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security, strategy or investment product. Such opinions are subject to change without notice. This publication is distributed for education purposes only. Information
contained herein has been obtained from sources believed to be reliable, but not guaranteed. Forecasts are based on propriety research and should not be interpreted as
an offer or solicitation, nor the purchase or sale of any financial instrument. No part of this publication may be reproduced in any form, or referred to in any publication,
without the express written permission of Smith Affiliated Capital Corp.

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