Puerto Rico's challenge

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Small country, big fiscal woes

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Puerto Rico's challenge

  1. 1. special Commentary commentaryPuerto Rico’s ChallengeMarch 2012Puerto Rico’s debt has long been attractive to municipal investors. The advisor, and primary lender to the Commonwealth, its political subdivisions,Commonwealth’s bonds carry high yields and are exempt from local, state, and and its public corporations. Puerto Rico’s growth and financial stability requirefederal income taxes. a healthy GDB.However, the Commonwealth today is flirting with insolvency, and the risk is The “Status Issue”growing that someday, Commonwealth investors may not be repaid, in full.Puerto Rico’s financial condition is far worse than any U.S. state’s, and a default – A perennial issue for Puerto Rico and its politicians is whether to supportthough unlikely in the immediate future – is a possibility over the next few years. applying for U.S. statehood. The island’s major political parties are divided on this policy matter, known as the “status issue.” A Commonwealth default wouldBreckinridge has long avoided obligations of Puerto Rico, but we believe likely compel a national discussion of the “status issue.” It is uncertain how thisall municipal bond investors should now be cognizant of its problems. A discussion would unfold and what it might mean for Puerto Rico’s bonds. 3Commonwealth default would have significant ramifications for the municipal However, the Commonwealth’s current Governor supports statehood.4market. EconomyIn this Special Commentary, we introduce the Commonwealth and its financialsituation, and we speculate on the market impact of a Puerto Rico bond default. The Puerto Rican economy entered recession in late 2006, and it has yetOur discussion begins with a brief introduction to the Commonwealth’s to emerge. Rising oil prices, government downsizing, and the end of taxgovernance, the “status issue,” and its economy. It next moves to an overview advantages for manufacturers were the immediate causes of recession. 5 Theof the island’s poor financial condition. We then discuss how recent reform Great Recession compounded the island’s problems.initiatives – coupled with the lack of a “trigger event” – make a default unlikely,at least in the near term. We conclude with a discussion of such a default’s Puerto Rico’s Real GDP Growth has beenimpact on the market and the legal precedents that might emerge from it. Negative or Modest for Several Years Source: Government Development Bank for Puerto RicoAn Introduction to the Commonwealth: 1.0%Government, Politics, Economy, & 0.5%Recession 0.0%Government 0.5% 2006 2007 2008 2009 2010 2011 2012 ForecastThe Commonwealth closely resembles a U.S. state. It has a bicameral legislature, 1.0%and its governor is elected to a four-year term. The island’s judicial system is 1.5%indistinguishable from a state court system.1 2.0%However, Puerto Rico is unique in its extensive use of public corporations to 2.5%deliver public services. It directly and indirectly manages 48 public benefit 3.0%corporations. 2 This governance structure has tended to limit transparency andfiscal accountability in its public sector. 3.5% 4.0%The island’s most important public corporation is the Government 4.5%Development Bank (GDB). The GDB is the fiscal agent, paying agent, financial 200 High Street, Boston, MA 02110 • Ph: (617) 4 43 - 0779 • Fx: (617) 4 43 - 0778 • w w w.bond inve stor.com
  2. 2. special Commentary, March, 2012 The island’s recent economic quagmire also results, in part, from decades of A Rising Debt Burden: Annual deficit financing has caused the island’s debt- industrial policy. Since the 1950s, the Commonwealth has invested heavily in to-GDP ratio to rise. It is now 90%, compared to 57% in 2001.13 In fiscal years infrastructure, education, and the development of high-tech manufacturing 2011 and 2012, the Commonwealth’s debt load grew while the economy to spur growth. Concurrently, the federal government has subsidized Puerto contracted.14 Rico’s debt through “triple-tax-free” bonds, 6 Puerto Rican manufacturers through corporate tax breaks, 7 and Puerto Rican residents through direct Puerto Rico’s Debt Burden is High and Growing transfer payments. 8 Note: Figures exclude unfunded pension and retiree healthcare oblications. Source: Government Development Bank for Puerto Rico These investments and subsidies have raised basic living standards.9 However, median household incomes in Puerto Rico remain at $15,000, and only 35% of Puerto Ricans are employed.10 Also, dependence on federal tax incentives and transfer payments has limited the island’s long-term growth prospects.11 Puerto Rico’s Financial Condition is Weak Poor financial management has contributed to the length and depth of Puerto Rico’s recession. The Commonwealth is burdened by large annual deficits, a high debt burden, opaque financial practices, and severely underfunded pension plans, among other problems. The credit characteristics we highlight below are not new, but they have worsened dramatically over the last decade: Annual Deficits: The Commonwealth has not balanced its budget in twelve years. The FY 2012 deficit (this year) will be roughly $1.4 billion or 17% of general fund expenditures.12 This calculation excludes the accrual of annual pension expense.   Inflexible Debt Structure: Puerto Rico’s debt structure is less flexible than The Commonwealth has Experienced Twelve other municipal issuers’. The Commonwealth repays only 21% of its debt within Consecutive Deficits 10 years.15 This means there is little potential to free up cash by extending Source: Official Statements, Public Improvement Refunding Bonds, Series 2012A, p. 11- maturities through refinancing. 3, February 1,2012 and Government Development Bank for Puerto Rico, Senior Notes, Series 2011A, p. 1-2, February 12, 2011. Politically Weak Bondholders: Relatively few Puerto Ricans own the island’s $0 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 bonds.16 Municipal debt is typically owned by resident taxpayers who pressure their politicians to avoid bond defaults, but Puerto Rico’s creditors have a more -$500 limited voice in its politics. Poor Forecasting: Puerto Rico consistently adopts aggressive economic and $1,000 financial forecasts. The Government Development Bank has missed economic growth forecasts for three consecutive years.17 Politicians continue to toutDeficit ($ millions) -$1,500 progress on relatively weak financial and economic data.18 -$2,000 Puerto Rico’s Growth Forecasts are -$2,500 Routinely Aggressive Source: Government Development Bank and Official Statements from bond offerings. -$3,000 GNP Growth (%) -$3,500 Forecast Actual FY 09 -3.4 -4.0 FY 10 0.7 -3.8 Deficit Financing: The Commonwealth has issued debt to finance its annual deficits. Unlike healthy municipal issuers, the Commonwealth requires market FY 11 1.0 -0.4 access to meet payroll and other obligations. FY 12 0.7 ? 200 High Street, Boston, MA 02110 • Ph: (617) 4 43 - 0779 • Fx: (617) 4 43 - 0778 • w w w.bond inve stor.com
  3. 3. special Commentary, March, 2012 Opaque Intra-governmental Borrowing: The Commonwealth’s major public Recent Reforms and Lack of a “Trigger corporations have significant and opaque financial relationships to each other Event” Suggest a Near-Term Default is and to the Commonwealth.19 These intra-governmental capital flows represent Unlikely a significant portion of the island’s financial activities20 and they are beginning Despite its poor economic and financial profile, the risk of a near-term default to impact the island’s larger issuers. Last year, almost 28% of PREPA’s (Puerto by Puerto Rico appears slim. Recent reforms appear sufficient to delay (if not Rico Electric Power Authority’s) unpaid bills were owed by delinquent public forestall) a default. Equally important, the “trigger events” most likely to induce sector organizations. 21 a Puerto Rico default seem unlikely. A Strained Government Development Bank (GDB): The Commonwealth’s vital Government Development Bank (GDB) is under stress. Roughly 35% of the Reforms GDB’s assets comprise loans to the Commonwealth and its public entities, The Commonwealth has implemented a series of financial reforms during the and most of these loans are paid late. 22 While the bank’s liquidity is ostensibly past two years that have positively impacted its credit quality and growth strong, it is weakly monitored. The GDB is unregulated by the Federal Reserve prospects. These reforms (outlined below) include: overhauling the tax or Federal Deposit Insurance Corporation. 23 system, 27 streamlining the island’s licensing and permitting process, 28 reducing government expenditures, 29 establishing a framework for public-private An Increasingly Politicized Government Development Bank: The GDB’s loan partnerships (essentially privatization of state assets), 30 and several changes to book has become a bit politicized. In recent years, the GDB has entered the pension system. 31 into “fiscal oversight agreements” with several of the island’s large public corporations. 24 These agreements require the public corporations to implement expense reductions, rate hikes, or submit to increased oversight Puerto Rico has Enacted Several Important to ensure the GDB is repaid. The bank’s intervention into areas traditionally Fiscal Reforms over the Past Two Years reserved for policymakers increases its repayment risk. Jan-09 Underfunded Pension Plans: Puerto Rico’s public pension funds were 14% Feb-09 funded in FY 2010, 25 and a staggering 22% of the funds’ assets include loans Mar-09 - Gradual reduction in operating expenditures (Act 7, March 2009) - Imposition of temporary and permanent tax hikes (Act 7, March 2009) to members of the fund. The Employees’ Retirement System may deplete its Apr-09 net assets by FY 2014 despite recent reforms. 26 The Commonwealth’s pension May-09 - Creation of a public-private partnership mechanism (effectively a “privatization” law) to raise cash funding shortfall is far worse than any U.S. state. Jun-09 and restructure the management of state assets. (Act 29, June 2009) Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Puerto Rico’s Pension Shortfall Far Exceeds That Dec-09 - verhaul of burdensome licensing and permitting processes to stimulate growth and entrepreneur- O of Other States Jan-10 ship. (Act 161, December 2009) Note: Figures are for 2010. Data for California reflects plans for state employees, only, Feb-10 and excludes teachers and public agency employees. Excludes pension reforms Mar-10 made for fiscal years beginning after June 30, 2010 Apr-10 Source: Merritt Research Services, LLC May-10 100% Jun-10 - stablishing an early retirement incentive which had a positive effect on pension systems’ actuarial E 90% value. (Act 70, July 2010)% of pension liability actuarilly funded with assets Jul-10 - reation of a new energy policy to reduce dependence on costly oil and foster renewable energy C 80% technologies. (Acts 82/83, July 2012) 71% Aug-10 70% Sep-10 63% Oct-10 61% 60% - eduction of corporate and individual income tax rates, enhanced tax compliance, and reduction R 53% Nov-10 in tax credits and exemptions to spur growth and increase tax collections. (Acts 154/171, 50% 45% November 2010. Dec-10 40% Jan-11 Feb-11 30% Mar-11 Apr-11 20% 14% May-11 10% - Immediate capitalization of pension funds with $163 million from the Commonwealth’s Infrastruc- Jun-11 ture Financing Authority. (Act 96, June 2011) 0% Jul-11 - Increase in employer contributions to the pension system (Acts 114/116, July 2011) Puerto Rico Illinois Connecticut Rhode Island California New Jersey - Lower the maximim amount a member can borrow from the employees’ retirement system pension Aug-11 fund from $15,000 to $5,000 to improve the system’s liquidity. (New regulation enacted by the Board of Trustees of the Employees’ Retirement System, August 2011) Sep-11 Oct-11 Nov-11 Dec-11
  4. 4. special Commentary, March, 2012Puerto Rico’s economy is now nearing expansion. 32 Tax collections have for Puerto Rican manufacturers in 2006. Many of the companies affectedalso improved, and the newfound ability to lease assets has buoyed the by the change moved jobs off the island or restructured their corporateCommonwealth’s cash flow. 33 Additional leases are planned, which should charter. It is likely a majority of job losses resulting from the 2006 taxfurther improve short-term liquidity and limit default risk. change have already materialized.Trigger Events Market Impact of a Default New LegalImportantly, the events most likely to set in motion a default seem unlikely in the Precedentsnear term. These mostly include risks associated with Puerto Rico’s dependenceon the capital markets and federal government. If the Commonwealth’s financial reforms prove insufficient to correct its financial imbalances or the above-mentioned trigger events become more plausible, aBecause it borrows frequently to fund operations, the Commonwealth must Puerto Rico bond default will become more likely. This would have a significantretain market access to avoid a bond default. A ratings downgrade, the impact on the municipal market and might result in legal precedents of interestelimination of the tax-exemption for municipal bond interest, or an increase to municipal investors.in mutual fund redemptions would threaten this access. However, all three ofthese events seem unlikely: Immediate Market Impact of Default • atings Downgrade: R Puerto Rico’s ratings of Baa1/BBB are barely The municipal market would likely react strongly and negatively to such a investment grade. A downgrade could force some selling and significantly default. The market remains largely dependent on retail demand, and Puerto limit demand. Fortunately, this scenario is unlikely in the near-term insofar Rico’s debt is held widely by municipal bond mutual funds. Also, bond insurers as rating agencies generally give struggling issuers time to implement are heavily exposed to the island. planned reforms. The retail investors who comprise the bulk of demand for municipal bonds • limination of tax-exemption: Federal tax exemption has supported retail E would likely be frightened by a Puerto Rico default. Such a default would demand for Puerto Rico’s bonds, which are exempt at the local, state, and invite disturbing but inaccurate headlines that Puerto Rico’s predicament federal level. Without this “triple tax-exemption,” Puerto Rico’s cost of presages U.S. state defaults. Investor skittishness could cause the market to borrowing would rise, as would the risk of a failed bond sale. Fortunately, underperform. Credit spreads would likely widen and liquidity might suffer. federal lawmakers seem aware of Puerto Rico’s dependence on triple-tax- A default would also directly pressure municipal bond mutual funds. Puerto free bonds, 34 and are unlikely to invite a default by pulling the subsidies Rico’s $60 billion in debt is held widely across these funds, 35 and a default for its debt would decrease their net asset values and share prices, inducing additional • utual Fund Redemptions: Many state-specific mutual funds are large M market outflows. buyers of Puerto Rico bonds, and they have supported the market for A Puerto Rico default might also place further strain municipal bond insurers. Puerto Rico’s debt quite well. Strong mutual fund inflows in recent years Nearly 28% of the Commonwealth’s public debt is insured. 36 To our knowledge, have given these funds the capacity to do so. However, when interest rates every major insurer has significant exposure to Puerto Rico. 37 begin to rise, these funds may enter a prolonged period of redemptions and their capacity to keep buying Puerto Rico bonds may diminish. If New Legal Precedents those redemptions coincide with further deterioration in Puerto Rico’s credit quality, mutual funds could become sellers rather than buyers. A Puerto Rico default might result in new legal precedents. These include (a) how to restructure a federal territory, (b) whether bondholders can reallyA debt crisis in Puerto Rico might also ensue as a result of federal government enforce contract rights against states, (c) whether certain tax secured bondsausterity measures. Cuts to Puerto Rico’s transfer payments and the end of dilute security for general obligation bondholders, and (d) the extent to whichfavorable corporate tax treatment could significantly impact the island’s credit “sovereign immunity” is a viable defense for a state’s non-payment of debt.profile. However, we believe the negative effects of these austerity policies areunlikely to materialize in the near future. Because it is a federal territory, there is significant uncertainty surrounding how Puerto Rico might restructure its debt. The Commonwealth is not a municipality, • ederal government cuts to Puerto Rico’s transfer payments. Puerto Rico’s F so it cannot adjust its debts through Chapter 9 of the bankruptcy code. 38 It is citizenry depends heavily on federal government transfer payments, also not a sovereign state, so it may have limited flexibility to renegotiate debt including those for food stamps, Medicaid, and social security. However, contracts. Instead, it is possible that Congress would compel Puerto Rico to the federal government is unlikely to cut these programs independent of adopt restructuring terms to its liking via the Constitution’s Territorial Clause. 39 a wholesale reform, and there are only modest savings to be generated by Some sort of “Congressional receivership” might prove the best option,40 but reducing payments to Puerto Rico’s residents. it is unclear how this would work. • ob losses associated with the end of the preferential corporate tax J A Puerto Rico default might shed light on the extent to which bondholders can treatment. Congress ended the “Section 936” preferential tax treatment enforce their contract rights against a state. Puerto Rico’s bondholders have
  5. 5. special Commentary, March, 2012 a first lien on Commonwealth resources. However, math and politics make it 1 See Sam Garett, “Political Status of Puerto Rico: Options for Congress,” Congressional Research Service, June 7, 2011. unlikely that bondholders will be paid, in full, if the Commonwealth cannot 2 For a listing of Puerto Rico’s component units, see the Commonwealth’s FY 2010 Comprehensive Annual both meet debt service payments and secure the public health, safety, and Financial Report, pp. 66-74. welfare.41 A ruling validating Puerto Rico’s ability to disregard its first lien 3 Puerto Rico would likely seek federal help if the Commonwealth defaulted. Federal involvement would necessitate a debate regarding the island’s legal status. Some Americans might support Puerto Rican statehood pledge could conceivably weaken bondholder protections outlined in other and a financial “bailout” in exchange for fiscal reforms. Others might seek to sever political ties with the island, altogether. states’ constitutions. Conversely, a ruling upholding Puerto Rico’s first lien 4 See Fox News Latino, “Puerto Rico Primary Gives a Push to Luis Fortuno’s Statehood Bid,” March 19, 2012. Available at: http://latino.foxnews.com/latino/news/2012/03/19/puerto-rico-primary-gives-push-to-luis-fortunos- pledge might strengthen bondholder security. statehood-bid/ 5 See “Trends and Developments in the Economy of Puerto Rico, Federal Reserve Bank of New York, “Current A default might also clarify when, if ever, tax secured bonds dilute security Issues,” Vol. 14, No. 2 (March 2008) for general obligation bondholders. The Commonwealth’s COFINA bonds are 6 Interest paid on Puerto Rico bonds is not taxed by federal, state, or local governments. This leads to a low cost-of-capital for the island nation. backed by a new sales tax levy that arguably diverts revenue away from general 7 Prior to 2006, foreign corporations operating in Puerto Rico could claim a large tax credit under section 936 of the federal tax code. Known as the “possession tax credit,” the favorable tax treatment drew many chemical obligation bondholders.42 It is unclear if Puerto Rico can segregate these sales and pharmaceutical manufacturers to the island. According to the Federal Reserve Bank of New York, more than 4% of the island’s private sector workers are employed in the pharmaceutical industry. This is more than taxes to the detriment of general obligation bondholders’ security.43 A ruling 10 times the mainland average. See “Trends and Developments in the Economy of Puerto Rico, Federal Reserve Bank of New York, “Current Issues,” Vol. 14, No. 2 (March 2008). that upholds Puerto Rico’s right to segregate these taxes might induce more 8 Transfer payments include those for social security and food stamps, among others. They are a significant part tax secured financing by U.S. states and reduce security for some general of Puerto Rico’s economy. In 2009, 32% of the federal government’s food stamp payments went to Puerto Rico. The island nation represents less than 1.3% of the U.S. population. obligation bonds. 9 See 2006 Center for the New Economy report. Available at: http://www.grupocne.org/information_bank/ FLMM.pdf Another question is whether Puerto Rico can defend itself against a suit for 10 This compares to 45% in the U.S. See: United States Bureau of Labor Statistics and Puerto Rico Department of Labor and Human Resources. Data available at: http://www.grupocne.org/information_bank/FLMM.pdf. nonpayment of debt by employing a sovereign immunity defense. The State 11 See 2006 Center for the New Economy report (March 2007). Available at: http://www.grupocne.org/ of New Jersey successfully defeated a union-led lawsuit on sovereign immunity information_bank/FLMM.pdf. See slides 24 - 26. grounds earlier this year.44 Puerto Rico has sovereign immunity rights,45 and it is 12 See UBS Wealth Management Research, Municipal Report Commonwealth of Puerto Rico (January 11, 2012). See also: March 7, 2012 Official Statement for Commonwealth of Puerto Rico Public Improvement possible (albeit unlikely) that the Commonwealth has retained these rights with Refunding Bonds, Series 2012A, p. 4. Available at: http://emma.msrb.org/EP611148-EP478117-EP878493.pdf. The Commonwealth reports a lower FY 2012 deficit in the Official Statement because it excludes $685 million respect to bonds. 46 in refinanced debt service from its calculation. Most financial analysts would include the refinanced amount. See the UBS report and the Center for the New Economy website note, available at: http://grupocne.org/ cneblog/?p=831. Conclusion 13 See Government Development Bank (GDB) Statistical Appendix of the Economic Report for the Governor and Legislative Assembly, Tables 3 and 29, available at: http://www.gdbpr.com/economy/statistical-appendix.html. Although the threat is not imminent and the risk remains slim, Breckinridge 14 See Government Development Bank (GDB) Statistical Appendix of the Economic Report for the Governor and Legislative Assembly, Tables 3 and 29, available at: http://www.gdbpr.com/economy/statistical-appendix.html. believes the possibility of a default by Puerto Rico is sufficient to warrant the See also March 7, 2012 Official Statement for Commonwealth of Puerto Rico Public Improvement Refunding Bonds, Series 2012A, p. I-56. Available at: http://emma.msrb.org/EP611148-EP478117-EP878493.pdf attention of municipal investors. 15 Figure includes debt guaranteed by the Commonwealth and revenue bonds. See: Puerto Rico’s FY 2010 Comprehensive Annual Financial Report, pp.137. A Puerto Rico default would have negative market implications. High grade 16 Most Puerto Rico bonds are held by mainland U.S. residents who are attracted to the island’s “triple-tax-free” interest payments. Affluent residents of New York City often find the bonds particularly attractive because they investors should understand the Commonwealth’s fiscal problems because a face high marginal city, state, and federal income tax rates. default might trigger mutual fund redemptions and bouts of illiquidity. 17 See Government Development Bank data and official statements from latest bond offerings. 18 For example, in February 2012, the Governor of Puerto Rico pointed to a modestly improved economic report as evidence that the island’s recession was over. His statement ignored the fact that economic growth, However, Puerto Rico’s debt situation is unique and unparalleled in the United as measured by the Government Development Bank, actually declined on a month-over-month basis. See “Puerto Rico’s recession is over, Governor says,” Feb. 21, 2012, Reuters. Available at: http://www.reuters.com/ States. A debt crisis in Puerto Rico will have limited impact – if any – on the article/2012/02/21/puertorico-economy-idUSL2E8DLFKI20120221. The GDB’s January 30, 2012 Economic extremely remote likelihood of a U.S. state default. Indicators report showed that the Commonwealth’s “Economic Activity Index” finished at 128.2 in November 2011 compared to the December 2011 figure of 127.7. See: http://www.gdbpr.com/economy/GDB-Economic- Activity-Index.html We end with a graph that illustrates just how different Puerto Rico is compared 19 At the end of fiscal year 2010, the Commonwealth’s public corporations owed $607 million to the primary government, and $3.6 billion to each other. During that year, the primary government expensed $2.7 billion a distressed U.S. state: Illinois. Illinois compares very favorably even though it in payments to the Commonwealth’s major public corporations. The Commonwealth’s primary government budget is roughly $20.7 billion. One expert, Sergio Marxauch, has noted that: “… the Byzantine structure of faces several years of large structural deficits and large pension and retiree our government, with its manifold executive departments, has generated a complete lack of accountability, healthcare liabilities. oversight, and transparency in government operations…” See: 2006 Center for the New Economy report. Available at: http://www.grupocne.org/information_bank/FLMM.pdf 20 See Puerto Rico’s FY 2010 Comprehensive Annual Financial Report, pp. 120 – 125. 21 See Municipal Market Advisors, Weekly Outlook, April 2, 2012.Puerto Rico’s Economic and Fiscal Condition 22 In FY 2010, $2.3 billion of the GDB’s public sector loans were delinquent by 90 days or more, an amount equalCompares Poorly — Even to Illinois to 27% of the GDB’s “loans receivable.” This figure is up from $510 million in FY 2006. Delayed loan collection is one reason the bank’s net interest margins (interest earned on lending less interest paid on borrowings) are low.* Includes revenue debt and state guarantees See the following sources: Official Statement, Government Development Bank for Puerto Rico, Senior Notes,GSP = Gross State Product Series 2011A and 2011B, December 21, 2011, pp. 10 and 25; Official Statement, Government Development Bank for Puerto Rico, Senior Notes, Series 2006A, February 8, 2006, p. 29; and Standard Poor’s January 27,Source: U.S. Bureau of Economic Analysis, Puerto Rico Planning Board, and 2011 rating opinion for The Government Development Bank for Puerto Rico. Comprehensive Annual Financial Reports, Illinois and Puerto Rico, FY 2010. 23 Instead, the Commissioner of Financial Institutions of Puerto Rico performs audit examinations of the bank every 18 months. See Standard Poor’s January 27, 2011 rating opinion for Government Development Bank Illinois Puerto Rico for Puerto Rico. 24 The bank has fiscal oversight agreements with the Highways and Transportation Authority, the Puerto Rico Population (millions) 13 3 Aqueduct and Sewer Authority (PRASA), the Electric Power Authority, the Ports Authority, the Puerto Rico medical Services Administration, and the Puerto Rico Health Insurance Administration. It also has a fiscal oversight-type agreement with the University of Puerto Rico. See: Official Statement, Government Development % of Population Employed 47% 35% Bank for Puerto Rico, Senior Notes, Series 2011A and 2011B, December 21, 2011. GSP per capita $50,938 $15,900 25 See Puerto Rico’s FY 2010 Comprehensive Annual Financial Report, pp. 196. 26 See March 7, 2012 Official Statement for Commonwealth of Puerto Rico Public Improvement Refunding Bonded Debt*/GSP 4% 90% Bonds, Series 2012A, p. I-56. Available at: http://emma.msrb.org/EP611148-EP478117-EP878493.pdf. However, note that Moody’s reports suggest a slightly brighter picture. Moody’s believes recent reforms have extended the Unfunded Pension Retiree Healthcare 16% 44% life of Puerto Rico’s pension funds by roughly six years. See Moody’s Investors Service, Issuer Comment, “Key Drivers of Puerto Rico’s Downgrade to Baa1,” August 10, 2011. At that time, Moody’s expected pension reforms Debt/GSP to extend the life of the ERS from 2019 to 2025. 27 Acts 7, 154, 171. Cumulative General Fund Deficit (FY 10) -16% -9% 28 Act 161. Federal Aid as % of Budget 30% 32%
  6. 6. special Commentary, March, 201229 Act 7.30 Act 29.31 Acts 114, 116.32 See Government Development Bank data. Available at: http://www.gdbpr.com/economy/GDB-Economic-Activity-Index.html33 The Commonwealth received a lump sum payment of $1 billion as part of a toll road leasing agreement inSeptember 2011. See March 7, 2012 Official Statement for Commonwealth of Puerto Rico Public ImprovementRefunding Bonds, Series 2012A, p. I-31. Available at: http://emma.msrb.org/EP611148-EP478117-EP878493.pdf34 See Report by the Joint Committee on Taxation, “An Overview of the Special Tax Rules Related to PuertoRico and An Analysis of the Tax and Economic Policy Implications of Recent Legislative Options,” June 23, 2006.Available at: http://www.jct.gov/publications.html?func=startdownid=1496.35 Mutual funds own Puerto Rico because it comprises 4% of the Barclays’ municipal market index, and 50%of the BBB portion of that index. Most funds are benchmarked to the performance of these indexes. See:Barclay’s Municipal bond Index, March 27, 2012. Note also that the $60 billion figure is from the GovernmentDevelopment Bank (GDB) Statistical Appendix of the Economic Report for the Governor and LegislativeAssembly, Table 29, available at: http://www.gdbpr.com/economy/statistical-appendix.html36 Breckinridge analysis of Bloomberg data, 3/23/2012.37 For example, Assured Guaranty has at least $4.8 billion in exposure to Puerto Rico, and the island’s debt alsocomprises six of the top 10 exposures for Financial Guarantee Insurance Company (FGIC). See: Assured andFGIC’s statutory statements, December 2011.38 See 11 USC 101(52).39 Congress is given broad powers under the Territorial Clause of the U.S. Constitution. See: Sergio Marxauch,“Municipal Fiscal Crises in the United States: Lessons and Policy Recommendations for Puerto Rico,” Center forthe New Economy, April 28, 2006, p. 1540 See Sergio Marxauch, “Municipal Fiscal Crises in the United States: Lessons and Policy Recommendations forPuerto Rico,” Center for the New Economy, April 28, 2006, p. 15.41 Section 8, Article VI of the Constitution of Puerto Rico gives general obligation bondholders a first claimon all available Commonwealth resources. However, math and the threat of public disorder have a way ofbending seemingly ironclad clauses in state constitutions. For example, the Commonwealth might argue thatits debts are merely those of a federal territory and that bondholders have limited legal recourse against afederal government sovereign – including its territories. This would be a novel approach, but it might workin conjunction with a federal bailout. Importantly, Puerto Rico has already demonstrated a willingness torestructure contracts to ameliorate its financial situation. Last year, the Commonwealth successfully abrogateda collective bargaining agreement on the grounds that it was reasonable and necessary to tear-up the contract.See: United Automobile, Aerospace, Agricultural Implement Workers of America International Union, et al. v.Luis Fortuno, et al., 633 F. 3d 37 (January 27, 2011)42 The Commonwealth’s most senior debt obligations are its general obligation bonds and its COFINA bonds.COFINA bonds are sales tax backed bonds that are, at least theoretically, insulated from general fundobligations. Puerto Rico’s general obligation bondholders have long been secured by the Commonwealth’s“available” resources, including its taxing power. But when COFINA bonds were created, lawmakers deemedthe sales taxes that backed them as “unavailable” resources.43 Prior courts have ruled that local governments may carve out specific “available” revenues to the detrimentof pre-existing general obligation bondholders. In fact, “dedicated tax” bonds are routinely issued across thecountry. However, Puerto Rico’s COFINA bonds were issued in a time of distress, arguably to the detriment ofgeneral obligation bondholders. Also, the only case we know of in which a carve-out was upheld against a generalobligation bondholder involved a tax increment financing district. In that case, the pledged revenue was nevermade available for general fund operations. COFINA bonds are supported by a sales tax, half of which flowsback to the general fund. This fact may have implications for the strength of the COFINA bonds’ dedicated taxpledge. The tax increment financing case is: Wolper v. City Council of City of Charleston, 287 S.C. 209, (1985).44 See N.J. Educ. Ass’n v. New Jersey, 2012 U.S. Dist. LEXIS 28683.45 See Porto Rico v. Ramos, 232 U.S. 627 (1914).46 Puerto Rico’s constitution certainly implies that the Commonwealth has waived its sovereign immunitydefense. However, the language in Puerto Rico’s Constitution is more vague than language used by U.S.states. Puerto Rico’s Constitution provides in Article VI, Section 2: “The Secretary of the Treasury may berequired to apply the available revenues including surplus to the payment of interest on the public debt andthe amortization thereof in any case provided for by Section 8 of this Article VI at the suit of any holder ofbonds or notes issued in evidence thereof” (emphasis added). It is unclear from this language whether PuertoRico’s Constitution refers to suits in Puerto Rican courts or in Federal courts. The U.S. Supreme Court has heldthat sovereign immunity rights are waived only when “the waiver is stated by the most express language orby such overwhelming implication from the text as will leave no room for any other reasonable construction.”See: In re Creative Goldsmiths of Washington, D.C., Inc., 119 F. 3d 1140 (4th Cir. 1997), at 1147. In other bondindentures, we often see a clearer statement of intent that includes words like “sovereign immunity,” “waiver,”or “governmental immunity,” among others.DISCLAIMER: The material in this document is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Nothing in this documentshould be construed or relied upon as legal or financial advice. All investments involve risk – including loss of principal. An investor should consult with an investment professional beforemaking any investment decisions.

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