Puerto Rico And Its Underwriters Appear To Be In Noncompliance With SEC Rule 15c2-12

Puerto Rico’s underwriters intend to sell $2-3 billion in new securities to the public--including retail--despite the fact that it is chronically noncompliant with SEC Rule 15c2-12, which requires timely financial reporting.

Here is what the SEC says:

“An underwriter shall not purchase or sell municipal securities in connection with an offering unless the underwriter has reasonably determined that an issuer of municipal securities has undertaken in a written agreement to provide annual financial information.”

Here is what Puerto Rico says:

“In light of the Commonwealth’s continuing difficulties in the timely filing of the Comprehensive Annual Financial Report notwithstanding the establishment of the policies and procedures described above, the Commonwealth is reviewing how to improve such policies and procedures to ensure timely compliance in the future with its continuing disclosure obligations.”

Here is Puerto Rico’s explanation of its noncompliance with SEC Rule 15c2-12:

The Comprehensive Annual Financial Report for fiscal year 2012 was filed by the Commonwealth on September 16, 2013, which is after the Commonwealth’s May 1 deadline, established in its continuing disclosure undertakings pursuant to SEC Rule 15c2-12. The Commonwealth was unable to finalize its audited financial statements on time due to (i) delays in the audit of such financial statements as a result of the government transition process, (ii) the adoption of new government accounting pronouncements, (iii) the restatement of the financial statements of the PRPA, a discretely presented component unit of the Commonwealth, and (iv) the failure of the University of Puerto Rico, a discretely presented component unit of the Commonwealth, to finalize its audited financial statements. The Commonwealth is evaluating the implementation of measures to ensure future timely filings of its audited financial statements. The Commonwealth has entered into several continuing disclosure undertakings in accordance with SEC Rule 15c2-12 in connection with its bond issuances. Although the Commonwealth has filed all the reports and financial statements required to be filed, some of these filings have been made after the Commonwealth’s filing deadline, which is normally May 1.

Puerto Rico has acknowledged that its financial reporting is noncompliant with SEC Rule 15c2-12. One might think that this would preclude the marketing of $2-3 billion in new debt securities. The underwriters for PR’s upcoming bond sale are Barclays, RBC and Morgan Stanley. It is not entirely without interest that Barclays is also a major creditor of PR. Would that not be a small conflict of interest? Wasn’t that the whole point of Glass-Steagall, to prevent banks from unloading their bad loans on retail investors?  

How can an underwriter sell bonds of an issuer whose financial disclosure  is 18 months old? How can a fiduciary buy the bonds of an issuer with no current financials?

It is amazing to me, a person who has been a market participant since 1978, that nothing ever changes, and that the Madoffs and the Enrons are as much in business today as they were in 1978. I am not advocating another Dodd-Frank; I am advocating the enforcement of existing law, and that the SEC should protect retail from buying dreck, which was the whole point of the Securities Act of 1934.

Why Puerto Rico Resembles Enron

Remember Enron? Enron financed its huge negative cashflows with debt it could never repay. It was a story of unconsolidated subsidiaries financed with layers of debt, extremely creative accounting and--toward the end--a deal that would solve everything.

Overlaid on the Enron story was the parallel saga of Enron’s external auditors, who slowly evolved from being an enabler into Enron’s nemesis. During the course of 2001, the external auditors came to realize that Enron’s reported financials bore no relation to the underlying economic (or legal) reality. They had been lied to. This led to delays in the release of financials. As news of the fraud began to dribble out, market confidence collapsed, Enron’s ratings were downgraded, its debt was accelerated and the firm went bankrupt with high loss severity. Enron sought to stave off its demise by promising to merge with another firm which would assume its huge debts. The deal was always “next week” until the end.

I don’t want to overdraw the analogy, but there are hints of Enron in the Puerto Rico story.

PR is a highly complex credit with multiple SPVs financed with debt, very large operating losses, and financial disclosure that is so late as to be useless. Puerto Rico’s most recent audited financials are from June of 2012. All subsequent financial reporting is unaudited. PR has repeatedly failed to comply with its commitments with respect to the timeliness of financial reporting. The financial reporting subsequent to the last audited report has not included a consolidated balance sheet, and instead consists of lists, tables and prose. PR’s principal financial unit is an unregulated “bank” which does not provide timely or adequate disclosure. The auditor’s most recent report (June, 2012) for the bank contains cautionary language regarding the collectability of the bank’s loans to the commonwealth and its borrowing vehicles and specifically mentions liquidity risks arising from rating downgrades (this was in 2012).

In fact, PR’s ratings have subsequently been downgraded and, as with Enron, the downgrades have triggered covenants permitting acceleration or additional collateral demands adding up to almost $1 billion. The government is trying to get the counterparties to waive these requirements. Nonetheless, the government is already experiencing cashflow problems:

“These factors have resulted in delays in the repayment by the Commonwealth and its instrumentalities of their loans to GDB and, at the same time, caused the Commonwealth and its instrumentalities to rely more heavily on short-term financing and interim loans from GDB and other lenders.”
The government's plan to resolve its liquidity crisis is to sell more debt into the previously nonexistent junk muni market.

As with Enron, the challenges associated with analyzing Puerto Rico as a credit are epistemological: what do we really know, and how do we know it? To borrow a phrase, we must sort out the known knowns, the known unknowns, and the unknown unknowns.

I would argue that everything we “know” since June of 2012 is based on unaudited information provided by the issuer. If PR was a corporation, its stock would have been delisted and its ratings downgraded long ago for this reason alone. (In municipal disclosure, everything is different--and inferior to corporate disclosure.) It is difficult to analyze a credit with unreliable financial information. Here is what the government has to say on the subject:

“In light of the Commonwealth’s continuing difficulties in the timely filing of the CAFR and the Commonwealth Report notwithstanding the establishment of the policies and procedures described above, the Commonwealth is reviewing how to improve such policies and procedures to ensure timely compliance in the future with its continuing disclosure obligations.”

Here are some of the “known unknowns”:

1. Consolidated monthly cashflows for 2014.

2. A current detailed balance sheet (consolidated and consolidating)

3. Consolidated monthly schedule of debt maturities.

4. Status of the negotiations with holders of accelerated debt or collateral receivable as a result of the rating downgrades.

Puerto Rico proposes to market a multibillion-dollar bond offering next month on the basis of its mid-2012 audited financials, and in the midst of a cash crisis. One hopes that the underwriters do not plan to market these securities to nonprofessional retail investors, but that hope is probably misplaced. Concerns regarding “suitability” are so old fashioned.

Enron was a huge mess to resolve, and a huge mess to prosecute. If Puerto Rico ever does default, it will make Enron look like a traffic case. Each entity will have to be resolved, each revenue stream will have to be fought over, each class of creditor will have to fight over venue and preference, on top of which there will be the legislature and the people of Puerto Rico. There is no legal precedent for any of this, which will vastly complicate the resolution.

Nothing like this has ever happened in the United States (or anywhere else), and when it’s over the legal documents will fill the Pentagon. It would make sense for the US to step in and help to resolve this mess, but that would be politically unpopular since Puerto Ricans pay no federal taxes and have no congressional delegation. Also, this would require placing a sovereign people under receivership, which would be difficult.

Will Puerto Rico do to munis what Enron did to merchant energy and what WorldCom did to telecom? That's an interesting question.

Puerto Rico's Latest Disclosures Regarding Liquidity

Yesterday, Puerto Rico published a new disclosure document and a slide presentation in connection with its upcoming bond offering. An excellent summary and trenchant analysis is provided by Cate Long at Reuters MuniLand. Below are what I think are among the crucial disclosures with respect to the Commonwealth’s liquidity crisis.
Bottom line: Unless the planned bond offering is successful, there is a significant risk that Puerto Rico will default and seek protection from its creditors under local law. Such circumstances make major fundraising difficult and raise the risk of a restructure.

1. GDB Liquidity

“One challenge that GDB faces is limited liquidity. The liquidity position of GDB has been adversely affected by, among other factors, the significant increase in credit spreads for obligations of the Commonwealth and its instrumentalities during 2013, by the limited market access experienced by the Commonwealth and certain of its public corporations during the second half of calendar year 2012 and calendar year 2013, by a significant reduction of liquidity in the local Puerto Rico capital markets, and more recently by the credit downgrades described above. These factors have resulted in delays in the repayment by the Commonwealth and its instrumentalities of their loans to GDB and, at the same time, caused the Commonwealth and its instrumentalities to rely more heavily on short-term financing and interim loans from GDB and other lenders.”

My conclusion: The government has exhausted its cash resources and is unable to repay its loans from the GDB.

2. Additional Funding Required

“The Commonwealth needs to obtain significant additional funding before the end of the fiscal year in order to repay interim loans and other obligations that are owing to GDB, and therefore allow GDB to continue serving as liquidity provider to the Commonwealth and its public corporations. Although the Commonwealth intends to access the capital markets in the near term, its ability to do so and the terms of any such financing are uncertain.”
My conclusion: The government/GDB will run out of cash this spring and must find significant additional funding before June.

3. Emergency Measures and Insolvency Risks

“The Commonwealth and the public corporations could also seek relief under existing Commonwealth law or under laws enacted in the future regarding insolvency, reorganization, moratorium and similar laws affecting creditors’ rights, which could affect the rights of the holders of bonds and notes of the Commonwealth and its public corporations and the enforceability of the obligations to make payments on such bonds and notes.”
My conclusion: Puerto Rico may seek insolvency protection under Puerto Rican law which could impair bondholders and other creditors.

What Are Puerto Rican Bonds Worth?

How should a straight unenhanced Puerto Rican GO trade? The market says it should trade above sixty cents. I think that is way off and creates a short opportunity for the brave. I say this for three reasons:

1. I expect PR to restructure its debt.

2. I think PR has very limited debt servicing capacity.

3. There is a risk that PR will impose a unilateral resolution on its creditors in the same way that Argentina and other Latin American countries have done.

4. There will be no bailout.

Likelihood of Default

Puerto Rico faces very large cash demands over the next month which can only be met by selling at least $2-3 billion in bonds. I don’t think that this can be done. PR has not sold a bond since last August, and has been trying very hard to go to market without success. The latest round of downgrades makes the task much more difficult. (The webcast for the planned bond issue is on Tuesday.)

Debt Capacity

PR has run large deficits for a long time, financed with debt. That debt now totals $60-70 billion and does not include around $40 billion in unfunded pension obligations. For PR to service its debt without further borrowing would require a level of fiscal adjustment that is politically impossible. PR will have to decide between massive government layoffs and debt reduction. That will not be a difficult decision for the Puerto Rican people to make. Most of PR’s debt will have to be forgiven one way or another.

Enforceability of Debt Claims

As best as I can tell, there is no explicit election of law in PR’s bond indentures. Because of the 11th Amendment, PR cannot be sued in federal court. Therefore it must be sued in Puerto Rico or New York. I expect that the Puerto Rican courts will defer to the legislature with respect to debt restructuring arrangements (notwithstanding the island’s constitution). That leaves New York, where a bondholder could seek a judgement against PR--assuming that the court decides to waive sovereign immunity. What I am unsure about is the enforceability of such a judgement. Would a New York judge impound PR’s deposits in US banks? It seems to me that trying to force PR to pay will be difficult and time-consuming. Therefore I would expect drawn-out and messy resolution process  that takes years to resolve, as in the case of Argentina.

No Bailout

Puerto Ricans are exempt from federal taxation, which makes a federal bailout seem inappropriate. Puerto Rico has no congressional delegation and very little political clout. Given the current fiscal posture of the House of Representatives, support for a federal bailout bill would be very limited and would come mostly from the minority party. I can imagine some degree of federal involvement in the debt resolution process, but not a bailout. I think that any federal involvement will be for the benefit of the Puerto Rican people, and not the bondholders. The future of the Puerto Rican economy is very bleak, and it can't devalue.

What would I pay for a Puerto Rico GO? Not more than thirty cents.

More On Puerto Rico

Today, the Puerto Rican government issued the following statement:

Puerto Rico expects to issue General Obligation (GO) bonds in the near term to refinance certain outstanding obligations and address the government’s liquidity needs. In order to fully address questions arising from rating agency actions and other recent developments, the Commonwealth’s previously announced quarterly webcast has been rescheduled for February 18, 2014. The webcast will provide additional details about the Commonwealth’s financing plan. Barclays, Morgan Stanley and RBC Capital Markets have been selected as joint lead managers for the upcoming GO bond issuance.

I have been wading into Puerto Rico’s financial disclosure, and would like to share my findings so far. My immediate reaction to what I have found is that this is a credit that is out of control. Disclosure has been chronically late despite repeated assurances to the SEC and the MSRB. The complete absence of fiscal discipline (until very recently) has allowed the government to run huge deficits for years. For example, in FY2012, the deficit was 27% of revenue. Debt has been growing much faster than the government’s deficit: in FY2012, the deficit was $2.4B while debt grew by almost $6.0B, presumably due to borrowing by other related obligors. PR’s debt ratios are on another planet compared to the 50 state medians. Its debt capacity appears to a fraction of its current indebtedness, given the history of intractable deficits.

I am working with the government’s most recent disclosure document, dated Oct. 18, 2013. It is not an audited annual report. The latest audited annual report is dated June 2012, and was filed in September of 2013. The government’s comprehensive annual financial reports have been chronically late.

What does the government’s spotty and untimely disclosure reveal? As far as I can tell, it reveals very substantial cash requirements for FY 2014 (which ends in June). The government says that scheduled FY 2014 debt servicing requirements are $3.4B. In addition, the government faces around $1.0B of debt accelerations consequent to the recent ratings downgrades. The operating deficit for FY 2014 is estimated at around $1.0B. I don’t know what the government’s pension funding requirements are for this year or whether they can be postponed. Assuming that the pension funding requirement is zero, that would suggest that the government must raise $5.4B, give or take a billion. I don’t see how it will be possible to raise anything near that amount without an investment grade rating.

Are my back-of-the-envelope funding calculations correct? The government has not provided a comprehensive schedule of cashflows for FY 2014. The GDB had scheduled an investor presentation for today, which has now been postponed for another week. Will the government use the webcast to provide useful and timely financial information for the benefit of prospective buyers of its new issue?  The onus is on the underwriters--Barclay’s, Morgan Stanley and RBC--to provide sufficient disclosure to prospective investors to satisfy the investors’ due diligence obligations as well as the underwriters’ own liability considerations.

I can't imagine that these banks would agree to underwrite these bonds if they cannot be substantially presold, so they must know something I don’t.

Puerto Rico's Cash Crisis

"We are confident that we have the liquidity on hand to satisfy all liquidity needs until the end of the fiscal year," Treasury Secretary Melba Acosta Febo and GDB Chairman David Chafey said in a joint statement following the S&P downgrade.--Reuters

How long before Puerto Rico runs out of cash and defaults on its debt? The tea leaves suggest that the debacle will occur either this month or next.

One might well ask, what is PR's financial condition? PR's financial disclosure is poor and infrequent. The last comprehensive annual report was published nineteen months ago, in June 2012. The June 2013 report has not been published yet (shades of Enron). There was some spotty disclosure in October which did not include financial statements.

What an investor (or bond analyst) could really use at this point are: (1) a recent balance sheet; and (2) a monthly schedule of proforma cashflow for the balance of the year. In my experience with distressed credits, financial statements are commonly delayed or unreliable prior to default. Transparency takes a back seat when default looms.

According to a recent statement, the government intends to borrow soon: "the GDB and the Commonwealth of Puerto Rico have been in discussions with parties that have expressed an interest in arranging additional liquidity for the Commonwealth". If so, I would imagine that prospective "liquidity providers" would demand up-to-date financials and proforma cashflows.

Reuters published a very helpful story on PR's liquidity situation yesterday, which provides some indicative tidbits. There is the following paragraph:

The timing of S&P's downgrade, coming just 11 days after the agency announced a review, was unexpected. 'If we have enough information to take action, we have to release it; otherwise we're holding onto inside information,' S&P's Hitchcock said in an interview. 'We do have confidential information on GDB cash flows and liquidity, and, based on the information that we do have, we feel that we had to take action.'

In other words, S&P saw the numbers and had to act fast.

And then there is this:

The GDB is searching everywhere to increase liquidity. El Nuevo Día, the most widely read newspaper in Puerto Rico, reported that the GDB is asking for loans from Puerto Rico banks, trying to get refinancing and forbearance on outstanding loans and bonds from local creditors and trying to sell real estate holdings.

The above paragraphs would seem to contradict the government's happy talk about having adequate liquidity. So while we don't know precisely when PR will run out of cash, we do know that it is imminent, unless its current fundraising activities prove successful, which is unlikely given the recent rating downgrades. Whatever hopes PR had for raising funds have been severely complicated by the fact that it is no longer rated investment grade by either S&P or Moody's. That precludes most conventional municipal investors from buying--or even holding--PR debt.

The next step would be for the government to announce a "temporary" moratorium on debt repayment pending a review of its situation and conversations with creditors. Being unable to seek bankruptcy protection, the workout will be difficult and litigious. I can only imagine that the government has already retained a workout adviser such as Goldman or some other firm which is not a big creditor. It is as yet unclear to me in what venue such litigation will occur. It is also unclear to me whether PR enjoys complete sovereign immunity or is subject to court decisions made in San Juan or New York.

The government has scheduled an investor briefing for this coming Tuesday, which could include some useful financial disclosure. I would hope that there would be sufficient disclosure to be able to calculate PR's debt capacity, however exiguous. This would provide investors with a sense for the valuation of the commonwealth's bonds. My understanding is that the bonds are still trading at levels that suggest a substantial recovery rate. From what I can see, that is very optimistic. More on this later.

The Selloff Is Rational

Thesis: The selloff indicates that the economy is much weaker than the recent growth data would suggest, and that the data will have to catch up with reality.

The Dow is off by 1200 points or almost 8% since the beginning of this year, and is down 600 points in just the past week. The official explanation for the selloff is investor doubt about the growth outlook, as signalled by the December jobs report and the January ISM report. Which is strange, considering that the markets received very bullish news from the 3Q13 and 4Q13 growth numbers, which were both quite strong.

It would appear that the market is currently ignoring good news and focusing on bad news, whereas before Christmas it only noticed good news. Have the facts changed or has sentiment changed? I think sentiment is catching up with the facts.

As readers know, I have been talking bearish since mid-December. I discounted the strong 3Q13 growth number and pointed to the weak December jobs number. I have no explanation for the 4Q13 growth number aside from the fact that it is inconsistent with my bearish outlook, and that the market agrees with me.

Although we have conflicting data points about the current rate of economic growth, there is nothing ambiguous about the current rate of money growth: slow and getting slower. The markets are unable to fight the Fed, and the Fed is the villain in this story.

Money growth has been declining for 18 months, from above 10% in the first half of 2012 to below 6% today, a 40% drop. A big chunk of that drop occurred in late-2013. Now, we know from Econ 101 that when both the money supply and velocity are declining, nominal growth must decline. And nominal growth has declined--until the last two quarters, which is why they look fishy to me.

From the monetarist perspective, the independent variable in the economy is M2 growth. M2 growth has declined to a dangerously low level, particularly given the ongoing decline in velocity, the transmission mechanism to the nominal economy. (Yes, I understand how V is calculated, but it is clearly declining.) We are in the midst of a low growth period as a direct result of Fed policy. (It is unacceptable for any central bank to argue that it can’t control the money supply, as Bernanke has explained to the Japanese and others on many occasions.)

Economics says that either the strong growth numbers are wrong, or else the weak money numbers are wrong. They are mutually incompatible. Being forced to decide between the bearish money data and the bullish economic data, I go with the stock market: I agree with the bearish money data.

Here is the Commerce Department’s reported real quarterly growth at seasonally-adjusted annual rates:

4Q12: 0.1%

1Q13: 1.1%

2Q13: 2.5%

3Q13: 4.1%

4Q13: 3.2%

There is certainly nothing bearish there.  But I don’t doubt the money data: when I look at the aggregates, they are all going in the same direction: M1, M2, M3 and M4. (The first two are from the St. Louis Fed, and the latter from the Center for Financial Stability). All of the aggregates show declining growth rates.

In my opinion, the selloff is rational and reflects a weak growth and earnings outlook. We will learn the answer as further growth-related data is dribbled out.

Conclusion: The selloff is rational and reflects weak growth. It won't reverse until the FOMC takes control of money growth.