On the verge of junk, government pledges to honor its debt
by Ron D’Vari, CEO, NewOak & James Frischling, President
Puerto Rico has been challenged by a population decline, persistent recession and budget deficits. While it is widely known that Puerto Rico’s current level of debt is unsustainable, the commonwealth has started to take meaningful measures to achieve a balanced budget.
Of key concern is defending its lowest investment grade rating, which has come under pressure and is on watch for downgrade to junk. Puerto Rican officials have tried to reassure the market that the government of Puerto Rico intends to honor its debt to its fullest ability. Some of the measures taken by Puerto Rico include spending control, pension reform, promoting economic growth, and enhancing and diversifying its revenue base, including increases to the Act 154 excise tax to 4%, and to its sales and use taxes.
The biggest challenge for Puerto Rico is its near-term actual or perceived liquidity, as any downgrade by rating agencies will trigger the need for additional collateral to post against its interest rate swap contracts and accelerated debt payments. As a result, Puerto Rico needs to demonstrate fairly quickly that it can access the bond market to cover potential short falls and maturing debt.
#2 Billion Debt Offering
According to various media reports, Puerto Rico is in talks with several banks and private investors to bring a $2 billion debt offering imminently even though it may not need it immediately. There is no doubt that the new debt will be costly and may not be pre-payable given Puerto Rico’s current financial challenges and the profile of potential investors willing to step up at this point and invest.
Similar concerns prompted the delay of a debt sale last summer. As of January 31, 2014, Puerto Rico bonds traded in excess of 7.4% over comparable 10-year U.S. Treasury bonds. Puerto Rico is considering several options, including issuing bonds backed by sales taxes which have recently been boosted to 6% from 5.5% by new legislation. Even a successful bond offering may not prevent the rating agencies from downgrading Puerto Rico debt. Given the concerns by the U.S. Treasury of potential ramifications for mutual funds of a possible downgrade, it is also expected that there could be some Federal assistance despite the territory status of Puerto Rico. Despite the cost, Puerto Rico’s only choice may be to demonstrate it can borrow money in the open market.
Court Approves Bank of America Mortgage Settlement—Or Did It?
A New York state judge approved “almost all” of an $8.5 billion settlement between Bank of America and investors, yet the words “almost all” fails to put this matter to bed. The original settlement, which was reached about 2 ½ years ago, was intended to settle claims by private investors over mortgage-backed securities that went sour during the financial crisis. Market participants had expected a black-or-white decision, but the result thus far appears to be a shade of gray.
The settlement has put investor titans at odds with firms like BlackRock, PIMCO and MetLife who favor the deal while an investor group led by AIG is opposed to it. At issue is whether Bank of New York Mellon as trustee was conflicted in the negotiating process. The judge ruled that the trustee acted in good faith, with the exception of the issue involving whether Bank of America should be responsible for modified loans as well as defaulted loans. With respect to the modified loans, the judge agreed the trustee failed to investigate loan modification claims. For lack of a better analogy, the judge deemed the trustee to be a little bit pregnant.
All sides are claiming to be emboldened as a result of the judge’s decision, with Bank of America being “pleased” that the court approved the settlement, and Bank of New York Mellon being “extremely pleased” that the court vindicated the trustees’ actions, and AIG being “pleased” by the judge’s exception for modified loans.
While it’s clear that all parties are at least “pleased” with the judge’s decision, what’s not clear is where things go from here. Bank of America has the right to put Countrywide into bankruptcy and highlighted that move as an option in the original settlement negotiations and again in connection with the court’s approval of the settlement. If Bank of America is satisfied with the settlement and the remaining outstanding issues, it’s safe to assume that the poison pill option is off the table. Maybe, maybe not—so far, nothing’s been swallowed yet.
