Puerto Rico Update

Puerto Rico Update
David R. Kotok
Cumberland Advisors October 29, 2013

There has been a recent flurry of activity regarding Puerto Rico, involving their debt, rating agency views of that debt, the bond insurers that have been insuring their debt, the state-specific mutual funds that are holding Puerto Rico debt, and the projected plans of the Puerto Rican government to improve their deteriorating credit picture and economic situation. We have new (August) economic information from Puerto Rico; see http://www.cumber.com/content/special/commonPREconomicactivityindex.pdf . And we have the October 18 detailed financial report linked below.

In this commentary we wish to add a few additional points to what is already an intense and public debate. At the end of this note we will offer our firm’s position on Puerto Rico’s debt. Many of the professional folks we spoke to about Puerto Rico’s debt situation asked for anonymity. They are under constraints from their firms, and we respect those restrictions. So our citations here will be from publicly available resources or our own computations.

We cannot say that Puerto Rico will default on all or some of its debt. Nor are we saying that it will pay all or some of its debt. We are saying the risk of default is high. As a skilled Washington-based expert said to me, “Puerto Rico might become an Argentina; and it might be able to turn itself around like Brazil.” Right now the best guess is that we do not know which outcome will prevail. However, we must add that the pressure to roll existing debt maturities and pay liabilities is nearing a critical point.

We’ve heard from debt holders who point out that hedge funds are buyers of Puerto Rico’s debt. They take that information as a positive indicator. We agree with the hedge fund purchase information. We disagree that it is a positive indicator. UBS’s Mike Ryan sums it well. “I would be really careful to play Puerto Rico or trade it” he said. “Hedge funds don’t own Puerto Rico. They rent.” (Barron’s, October 28)

My colleagues Michael Comes, John Mousseau, and I took apart a hedge fund trade. We reconstructed ways in which hedge funds can buy Puerto Rico and also hedge the other side of the trade for their profit. They can take long positions in Puerto Rico debt. They offset the risk through either a short position or put option on Assured Guarantee stock. Assured Guarantee is the major bond insurer of some Puerto Rico debt. Alternatively, the hedge fund can use a credit default swap on Assured Guarantee. In either case they try to neutralize their Puerto Rico default risk by using Assured as a proxy.

The theory behind this is that Assured Guarantee would be hurt if Puerto Rico defaults. So, the hedge fund’s long position would lose from a Puerto Rico debt downgrade or default, but it would have an offsetting gain from the credit default swap position or short position on Assured Guarantee stock. The offsetting neutralized position could result in a profit to the hedge fund. In fact, my colleagues and I calculated that the hedge fund could assume a neutral duration position and thereby create about 350 basis points in an annualized tax-free yield. That yield would also be a tax-free yield to the hedge fund’s investors. So the typical hedge fund investor can derive a taxable-equivalent yield of about double the tax-free yield, or about 7% on a maturity structure that can be unwound in only a few days. That is without leverage. My colleague John Mousseau noted that some hedge funds may be able to lever this up to 20 times.

There is still counterparty risk when putting such a trade together. And the position needs continuous rebalancing, since it has three or more moving parts and constantly adjusting weights. But that is exactly what a hedge fund is supposed to do. What we want to show is that there are ways to do it. Furthermore, note that the starting point of the trade is buying Puerto Rico debt, not because you like it but because it offers a hedging opportunity in a distressed market.

We want to demonstrate this with a chart that we have posted on our website for all to see (http://www.cumber.com/content/special/puertoricocomplexity.pdf). (We suggest that you view the image as you follow this discussion.) We have used Bloomberg data and constructed three series. (1) The Assured Guarantee stock price is in orange; that company is the bond insurer that has the dominant position with respect to Puerto Rico credit enhancement. (2) The Assured Guarantee credit default swap is depicted in green; it is inverted so that it can be visually compared to the stock price. (3) The price of the general-obligation bond of Puerto Rico is in blue. The similarities in price change are obvious to the eye and well supported by the math that one would use to determine how tightly these are correlated. That is the math that helps to guide the hedge fund as it rebalances the weights. We’ve also marked the Detroit bankruptcy date and the Barron’s Puerto Rico article date with respect to the front-page description of Puerto Rico. These two dates are important because they introduced headline risk. Please note that Assured Guarantee also has exposure in Detroit.

Readers can now make their own determinations about this so-called “bullish” hedge-fund trade. We will move on to the issue of credit risk.

At www.cumber.com, underneath the chart of the hedge-fund trade, readers may find the “Commonwealth Of Puerto Rico Financial Information and Operating Data Report,” dated October 18, 2013. Here is a direct link: http://cumber.com/content/special/october18commonwealthreport.pdf . One can peruse it and see that about 40% of the revenue for the government of Puerto Rico is coming from the federal government of the United States. The details are in the report. The report is very comprehensive, and that is a positive from this beleaguered bond issuer. Such reports are now required under the newest versions of disclosure rules.

Read the details about the pension systems, which are in horrible straits. Various retirement funding liabilities of Puerto Rico are estimated at $37 billion by methodologies that include a 6% discounting rate to get to present value. The reports show that the pension system is only 8% funded, meaning it is 92% unfunded. On digging deeper, one can find that a substantial amount of the funded portion is in the form of assets consisting of small loans, mortgages, and certain cultural loans to participants. Those “assets” substituted for what otherwise would be cash or investments in the pension system.

We excerpt this quote from the report:

“Another cause for the current situation of the Employees Retirement Systems is its personal loan program. The Employees Retirement System offers and manages a program that offers personal loans, mortgage loans and loans for cultural travels for retirement plan participants. Participants may obtain up to $5,000 in personal loans for any use. In 2007, the System increased this amount to $15,000, which reduced the cash in the System by approximately $600 million between 2007 and 2010. This deficit has been covered by funds from the System itself and has required the liquidation of assets that would have otherwise been available to make pension payments. Due to the amount of personal loans originated during recent years, the System’s loan portfolio now has a significant amount of illiquid assets. In an effort to improve the situation, in 2011, the Board of Trustees of the Employees Retirement System lowered the maximum loan amount back to $5,000 and, in 2012, it approved the sale of approximately $315 million in loans. With a balance of $539 million as of June 30, 2013, personal loans are equivalent to approximately 76% of the Employees Retirement System’s net assets.

“Finally, in 2008, the Employees Retirement System issued $2.9 billion in pension obligation bonds (“POBs”). The purpose of this offering was to increase the assets of the System available to invest and pay benefits. Unlike some other U.S. jurisdictions that have used this strategy, POBs are obligations of the Employees Retirement System itself and government employer contributions constitute the repayment source for the bonds.

The Commonwealth and other participating employers are ultimately responsible for any funding deficiency in the Retirement Systems. The depletion of the assets available to cover retirement benefits would require the Commonwealth and other participating employers to cover such funding deficiency. Due to its multi-year fiscal imbalances previously mentioned, however, the Commonwealth has been unable to make the actuarially recommended contributions to the Retirement Systems. If the measures taken or expected to be taken by the current Commonwealth administration fail to address the Retirement Systems’ funding deficiency, the continued use of investment assets to pay benefits as a result of funding shortfalls and the resulting depletion of assets could adversely affect the ability of the Retirement Systems to meet the rates of return assumed in the actuarial valuations, which could in turn result in an earlier depletion of the Retirement Systems’ assets and a significant increase in the unfunded actuarial accrued liability. Ultimately, since the Commonwealth’s General Fund is required to cover a significant amount of the funding deficiency, the Commonwealth could have difficulty funding the annual required contributions if the measures taken or expected to be taken to reform the retirement systems do not have the expected effect. There may also be limitations on the Commonwealth’s ability to change certain pension rights afforded to participants in the Retirement Systems.”

There is no way we can predict when a pension system will fail to pay its pensioners. We can say that this is a terrible funding situation for promised retirement benefits. Puerto Rico is essentially operating on close to a pay-as-you-go basis. It has far worse pension funding than any of the 50 states in the US. We have not included the promise of post-retirement health benefits, which only make the funding ratios worse. These are among the reasons why The Economist calls Puerto Rico a “Greek-like crisis on America’s southern doorstep.” (The Economist, October 26)

There is a second derivative at work now in dealing with state-specific mutual funds. Remember that Puerto Rico debt is tax-free in the various states and cities. State-specific funds can and do hold Puerto Rico debt as part of their composition. We think the involvement by states makes the exposure to Puerto Rico debt a nationwide issue, as opposed to the narrowness of exposure to the debt of Detroit, Stockton, or Harrisburg. A person in Arizona is not likely to own a tax-free bond from Detroit. Such a bond would be subject to taxation by Arizona. But a Puerto Rico bond could be held by any state-specific investor, because it would be tax-free. Mutual fund investors in state-specific funds may not know the exposure their fund has to Puerto Rico. The Oppenheimer Rochester funds have been mentioned by Lipper as having “the highest concentration of Puerto Rico bonds in the industry.” (Reuters, October 16)

Rating agencies have Puerto Rico debt on negative watch and have it rated at the lowest level of investment grade. The ratings story is in the report and is available to those who subscribe to the rating agencies. There is not much we will add to it. But in our internal rating work at Cumberland we also consider population shifts and crime rates. This data is not positive for Puerto Rico.

Puerto Rico has a financing plan that it is trying to advance in order to raise between $500 million and $1.2 billion in the next round of bond issuance. The subject of Puerto Rico has been explored by a number of Wall Street firms and research houses and has been a topic at several conferences. We cannot say whether Puerto Rico will successfully be able to roll its debt. We can project that any financing will be at a high cost, imposed upon an economy beset by questionable growth, a history of chronic deficits, a huge per-capita debt load, and a nearly exhausted pension fund.

Since we have written about Puerto Rico and taken a hard-line negative position on its debt, naturally we have received emails regarding our position on Puerto Rico. We wish investors well. And we certainly hope that the Commonwealth of Puerto Rico finds a way to avoid any defaults and to keep its promises to pensioners. We are not cheering for the demise of this beautiful island, where 45% of its 3.5 million inhabitants live below the poverty line and where the debt-to-GNP ratio is estimated at about 140%, if the pension liability is included.

That said, we think there is additional headline risk of trouble in Puerto Rico; there is risk of a debt-service-payment miss in the event that Puerto Rico finds itself with insufficient cash flow to meet debt-service payment; and there is market risk if the Commonwealth fails to obtain sufficient market access so that it can roll the debt. At Cumberland, we are not holding Puerto Rico debt — we do not own it, and we would not buy it today. The same is true for any mutual fund with exposure to Puerto Rico.

David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors