Thursday, January 23, 2014

Puerto Rico On The Brink Of Default

Investment thesis:
The Commonwealth of Puerto Rico will default soon.

It looks like the Puerto Rico debt crisis is rapidly coming to a denouement. The FT has a nasty story about Puerto Rico’s debt situation in today’s paper. The picture it paints is very bleak. CPR is a classic case of an over-indebted government which needs to borrow to finance operating deficits and to refund maturing debt. The government has run out of time to fix its finances. It needs to borrow more money than it can raise.

Three indicators suggest that the end is nigh: (1) Moody’s is very likely to  downgrade CPR to junk status in the near future, judging by the tone of its research; (2) the market rumor is that CPR will soon announce a debt moratorium; and (3) CPR’s creditors are meeting with debt restructuring experts.

It is impossible for a credit to recover from such a triple-whammy, whether a moratorium is planned or not. The government says it has enough cash to stay alive for the rest of the year, and it is hoping to issue new debt. Both facts may be true, but I am reminded of Enron and Lehman: a point is reached at which the credit cannot regain market confidence, and events  take charge.

Moody’s reports that CPR’s cash position is dwindling, and that a downgrade would make things worse: “The commonwealth has swaps and financings that include collateral and acceleration provisions in the event of a one-notch downgrade by any of the three major credit rating agencies. We estimate that a one-notch downgrade could result in liquidity demands of approximately $1 billion.” In the context of CPR’s proforma cashflows, $1B is material.

CPR has between $60-$70B of debt, depending on what you count, plus another $40B in unfunded pension liabilities. Moody’s compares CPR’s debt ratios to the 50-state median, which indicates that CPR’s indebtedness is an order of magnitude greater than the typical state. Debt to GDP is 72% for CPR and 2% for the median state. Debt to government revenue is 260% versus 42% for the median state. Although CPR doesn’t pay federal taxes, Moody’s says that its debt burden is “high by all comparisons”.

CPR is an interesting case, because its constitution prohibits bankruptcy, it is ineligible for federal bankruptcy, and it is required to service debt before all other expenses. The CPR government claims that this means it can’t default, but it can and it will. A deus ex machina rescue by the US Treasury is extremely unlikely. I don’t think that Treasury has any such authority, and I don’t see the House GOP caucus agreeing to bailout legislation (a bad precedent--and CPR doesn’t pay federal taxes). What is more likely is that Congress will establish a restructuring authority to administer the workout.

Will a CPR default be a big deal, or will it be a snooze? My sense is that it will be a snooze because it really has no implications for other credits, so there should be little contagion. It should raise credit spreads for weak municipal credits, but that is no catastrophe.

CPR can be analogized to the bad credits in the eurozone, in the sense that it lacks its own central bank, can’t print its own money, and can’t service its debts. Like Cyprus and Greece, its creditors will have to be “bailed in”. I haven’t looked at CPR’s banking system, but they are full-fledged members of the FRB/FDIC complex, which should provide a safety net.

Investment conclusion:
A CPR default should not be contagious, but will startle the muni market.

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