Sunday, February 23, 2014

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.

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