Puerto Rico Financial Troubles Deepen

Bloomberg news reported this week that the President of the Commonwealth of Puerto Rico Senate was headed to Washington to meet with US legislators. The purpose of his visit is to lobby for an amendment to Chapter 9 of the Federal Bankruptcy Code, to allow the struggling Island to be covered under the same bankruptcy statute now available to US cities, counties and local districts.  A similar measure adopted by the Commonwealth in June 2014, the Puerto Rico Corporations Debt Enforcement and Recovery Act, was struck down by US courts as unconstitutional this past February. US Treasury Secretary Jack Lew has already informed the Island that a Federal bailout is not in the cards. 

With the news of Puerto Rico's approach to Washington breaking, it should be quite evident what the Island's plan is for resolving the debt crisis. The Commonwealth, along with the Teachers' and Judicial Retirement Systems are struggling with $37 billion of unfunded pension liabilities, high debt loads, a sluggish economy, falling tax revenue and a declining population.

For holders of the roughly $72 billion of bonds issued by the Commonwealth, this is a bit more salt in the wound. The struggling protectorate issued $3.5 billion in tax-exempt bonds in March 2014 to help stabilize its finances, constituting the largest municipal junk bond offering in history. The bonds, largely sold to hedge funds and offered at an initial price of 93 now trade around 80, resulting in a loss of 13% to those who purchased at the initial offering price just last year. Paulson & Co is reported to be one of the largest purchasers of the 2014 deal, along with DoubleLine. Commonwealth bonds are also owned by Fir Tree Partners. With the recent decline in prices, yields on Puerto Rico triple tax-exempt bonds are now higher than taxable bonds of Greece and Argentina.  

Revenue of the Island this year is projected to come in at $250 million below prior estimates, with a looming budget gap of nearly $200 million to be resolved by the end of the Commonwealth's fiscal year, this June 30. As a solution to the budget issues, legislators have proposed a $500 million reduction in spending and a hike in the Island's sales tax from its current rate of 7% to 11.5%. In addition, a bond payment of $630 million is due the first day of the new fiscal year, or July 1.  

The Puerto Rico Electric Power Authority (or PREPA) faces budget and financing challenges of its own. The Island's main energy provider is negotiating with creditors to whittle down its $9 billion of debt and avoid a default on a $416 million bond payment, also due July 1. With no legal remedies available to it and all sides lawyered up, this looks to be heading for a messy and involved litigation.

San Bernardino Circles the Drain

Just released were details of San Bernardino's bankruptcy recovery plan. Referred to more delicately as a "plan of adjustment", the proposal calls for repaying bondholders one-percent of their investment in city bonds, or a penny for every dollar loaned the city. Perhaps encouraged by the City of Stockton, who in its bankruptcy reorganization plan repaid investors 11 cents per dollar, it's nonetheless a punishing outcome for those who invested their savings in municipal bond funds that hold San Bernardino bonds.  

Further reported in the city's plan, are significant reductions to its firefighting forces, in a region well-known for wildfires. The bankruptcy plan also calls for cuts to ambulance services, park maintenance and graffiti removal, while extending a temporary sales tax, approved by voters back in 2006. As if these cuts to services weren't troubling enough, given the drubbing bondholders will take on their investment in San Bernardino bonds, it's hard to see how the city will raise money in the future for needed public projects. Fool me once...

A study of salaries of the 120 highest paid firefighters in San Bernardino reported by Bloomberg shows the top one-third drawing an average salary of $190,000 per year; the next third $166,000. In retirement, as early as age 50, these firefighters may be eligible for annual pensions of up to $171,000 per year, an obligation the city will need to pay for many years to come. This might, in part, explain the types of management decisions that led up to the city's bankruptcy. 

Nevertheless, it has us wondering just what becomes of cities like San Bernardino, Stockton and Detroit. Higher taxes, reduced services and limited public improvements are hardly the building blocks of future growth and economic prosperity. Yet 200,000 residents continue to call San Bernardino their home, raise their families there and seek to enjoy its public amenities. The city has let these residents down, much in the way it now proposes to let down investors who loaned it money to build out its infrastructure. Let's just hope, and against significant odds, that the city's plan of recovery actually works.

Chicago Junk Bonds

Hard to believe it's come to this, but municipal bonds issued by the Second City are now considered junk bonds. Moody's lowered the rating on Chicago's bonds this week to "Ba1", below investment grade. The rating change was prompted by the rating agency's continuing concern with the city's public employee pension liabilities. The unfunded portion of the city's ten public pension funds now totals a daunting $37 billion. Standard & Poor's and Fitch continue to rate the city in the "A" category, however, showing a considerable divergence in views with Moody's on the depth of the city's woes.

The rating change for the city comes on the heels of a recent ruling of the Illinois State Supreme Court, which just last week struck down a pension reform measure championed by Governor Pat Quinn and passed by the Illinois State Legislature in 2013. That ruling, potentially disastrous for the state facing its own massive unfunded pension debt, also has negative implications for Chicago.

The rating change affects over $8 billion of bonds outstanding, with investors holding those bonds seeing their price degrade day by day. General obligation bonds issued by the City of Chicago in 2012 and due in 2033 yielded just 3.75%, or a spread of roughly 100 basis points to high quality municipal bonds. By 2014, however, with concerns already beginning to emerge about the city's pension problems, bonds of the city of equivalent maturity were sold at a yield of 4.87%. The yield represented a spread of 170 basis points to the high quality index.

As of today, those same bonds issued just last year at 4.87% are now trading at a yield of 5.51% or at a spread of 2.81% to the index.  With price moving inversely to yield, this represents a loss of $5.45 per $100 of value (or 5.45%) to investors who purchased the bonds at the offering just last year. If the bond ratings are similarly dropped by S&P and Fitch, the bonds will unquestionably fall much further in value.

Far higher interest rates on new borrowings of the City and the losses suffered by investors in the city's outstanding bonds may be the least of it, however, with interest rate swaps entered into by the city from years earlier posing a vexing problem for the troubled city. The downgrades may permit banks that had entered into interest rates swaps and other derivative products with the city to now demand payment on upwards of $2.2 billion of those agreements. Similar downgrade provisions helped force Jefferson County, Alabama into bankruptcy a few years earlier.

The past few years have seen some of the largest, and most frequent bankruptcy filings of local government in US history. Jefferson County, Alabama, the cities of Vallejo, Stockton, San Bernardino, Central Falls, Harrisburg and Detroit have all filed, largely due to excessive debts and pension liabilities. The Commonwealth of Puerto Rico, with a staggering $73 billion of US municipal debt outstanding now teeters. Chicago, now in junk status, is on deck.