PUERTO RICO Crunch Time for the Commonwealth

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1 PUERTO RICO Crunch Time for the Commonwealth As the calendar turns to September, Puerto Rico (PR) enters a critical phase for debt and cash management. Over the coming weeks, PREPA bondholders, a soon-to-be-named Chief Restructuring Officer (CRO), and the newly appointed Puerto Rico Commission on Energy (CEPR) will be required to strike a deal to restructure PREPA s operations. Meanwhile, continued weakness in the real economy threatens to derail fiscal consolidation plans as Governor Alejandro Garcia Padilla s administration has had trouble executing some of the reforms essential to reductions in the projected FY2015 deficit. Liquidity concerns continue to linger in the backdrop as negotiations with banks and bondholders over short-term cash financing persist, but in our estimation, closing these transactions before the end of Q1 (September 30) could be an important benchmark. In this report, we recap some economic data that may be important to investors thinking about their investments in general obligation (GO), Puerto Rico Sales Tax Revenue (COFINA), and Government Development Bank (GDB) bonds. In light of last month s Economic Activity Index (EAI) numbers, which were down an additional 0.7 percent year-overyear, we review our thesis about economic growth, revising down our projections for growth in the coming year to a 1.0 contraction. With this in mind, we highlight some execution risk in the 2015 budget, including yet-to-be-introduced efforts to reform the tax code and make the teacher s pension system more sustainable. Finally, we lay out a timeline of key dates for PREPA s bondholders, including the September 8 deadline to name a Chief Restructuring Officer. In general, we believe that default at PREPA is a highly probable event, and that default at HTA and PRASA may follow. At this stage, however, we continue to believe that the debt load of the general fund is sustainable under IMF debt sustainability principles, and as such, we continue to place the odds of default at or below 30 percent. Economic Data Softer But Steady; Slower Contraction But No Growth. In earlier reports, we projected the PR economy would decline around 0.7 percent in FY2014 due to strong fiscal drag weighing on growth. Now, we believe the decline in the economy will be steeper, with the annual contraction registering at 1.0 percent. The decline in the real economy is driven principally from austerity, but a slowdown in the growth of key industries notably, financial services and tourism has been compounded by a slowdown of capital flow to the island. Since June, capital flows in Puerto Rico have fallen $350 million on a year-over-year basis, according to our calculations using data from the Planning Board and Chamber of Commerce. In short, the economy is contracting faster than expected, partially because of a slowdown in funds flowing from the United States. In our estimation, the slowdown is reflective of the uncertainty engendered by continued fiscal turbulence on the island; with little certainty about the path of the budget or the fate of public corporations, what little comparative competitive advantage PR may have had is likely to have evaporated. Figure 1. Real Gross National Product Projections Planning Board Baseline Height -- Baseline Case Height -- Pessimistic Case Source: Puerto Rico Planning Board, Government Development Bank of Puerto Rico, Puerto Rico Office of Management and Budget, and Height Securities LLC s calculations.

2 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 Jan-14 May-14 Washington, DC September 2, 2014 EAI Continues Decline, Bears Watching as a Leading Indicator. The EAI is a better leading indicator than coincident indicator, as its month-over-month volatility makes it a poor snapshot of economic activity. The R-squared value of EAI s 3-month lagged percentage change against real GNP is higher than its coincident R-squared by 3.2 percent, though both are well above 0.9. As a consequence, the laggard pace of the economy over the summer ought to give investors pause. As we have written at length previously, however, the EAI does a poor job approximating the growth the economy because of the way the economy has rebalanced and because of poor weighting in the EAI s underlying data. Height s reweighted data also includes components for retail sales and hotel registrations, and while the index continues to be sluggish, it looks somewhat better than the official index. We would note, however, that the official index and Height s version are both rather dismal, and for the first time since we began calculating our own index, the strength of the retail sector and tourism sector are insufficient to pull the index upwards away from the GDB s original version. Three of four major components registered in negative territory in July 2014, and the pace of private sector hirings has gone flat all across the PR economy. One key reason to watch the PR tourism sector is because of its ability to reintegrate disenfranchised workers into the economy, but the sector s hiring has slowed to effectively zero in the past two months. Anecdotally, resorts, hotels, and casinos are all reporting a decrease in revenue over the summer compared with their prior years, and in hearings before the Senate, some proprietors have asked to amend their business hours to cut staff and cope with the slowdown. We would also note that credit contraction in PR has continued unabated. Figure 2. Comparative Economic Activity Indices GDB EAI Height EAI Source: Government Development Bank for Puerto Rico and Height Securities LLC s calculations. Legislative Changes Yet to Be Proposed by the Governor. The governor s fiscal team has heavily telegraphed its legislative priorities for the year, which include tax reform, reform of the teachers pension system, and an inquiry into the health care system (Mi Salud). Tax reform is expected to be revenue neutral, and should be bolstered by a longawaited transition from a Sales and Use Tax (IVU) to a value-added tax (VAT). A VAT is a more flat tax to collect since the tax applies broadly to all goods and services on the island, and while the VAT requires extensive maintenance to ensure proper accounting and rebating, the current IVU system has so many loopholes, extensions, credits, and rebates that the prospects for evasion and manipulation should drop alongside the cost of compliance as businesses and the government work to adopt a new tax measure. The governor s fiscal team would also like to pursue corporate income

3 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Washington, DC September 2, 2014 Figure 3. Year-over-Year Percent Change 3-Month Moving Average, EAI Comparison GDB EAI Height EAI Source: Government Development Bank for Puerto Rico and Height Securities LLC s calculations. Figure 4. Commercial Loans and Leases, Year-over-Year Percent Change Source: Government Development Bank for Puerto Rico and Height Securities LLC s calculations.

4 tax reform, but it is unclear how the administration would achieve income tax reform without losing revenue in the process. Meanwhile, the prospects for reforming the teachers pensions system do not look bright, especially since the governor recently reportedly struck an accord to cut teacher salaries by 6 percent in the next fiscal year. In our estimation, the PR Supreme Court is unlikely to allow a reform to the teachers pension system to stand if it does not create actuarial solvency, but the size of cuts required to create actuarial solvency are too politically difficult for the governor to contemplate. Perhaps the administration will simply elect to work higher transfers from the general fund into budgets through 2016 and punt reform until after the next election. Finally, requests to replace part of the managed care provisions in Mi Salud in the spring did not go well, mostly because healthcare providers were unwilling to renew the program at present rates. A new request for proposals (RFP) for Mi Salud should go active soon, as the current arrangement expires on January 1. In our view, the cost of Mi Salud is likely dramatically understated for FY2015 and beyond, as we expect the cost of care per recipient to increase by at least half for more than 40 percent of Mi Salud s care load. That implies the cost of PRHIA could be around $3.20 billion in this year, against a budgeted $2.67 billion. The incremental $534 million may need to come from the general fund, and the Commonwealth will need to get a health provider to agree to even the 50 percent increase in order to effect this change. Reports from the initial failed RFP in the spring are that the demand among health providers was for a nearly 100 percent increase in the reimbursement rate for Mi Salud; Humana has cited this as a driving factor behind its reduction in PR activity. Execution Risk Still Paramount; Liquidity Needs to Come Sooner Rather Than Later. With the government failing to execute on a variety of reform efforts in the first 60 days of the new budget, liquidity needs are coming into focus. This month, the implementation of the new port-collected IVU should bring about higher compliance, but relatively abysmal tax collections in July should concern investors. While the headline figure ($663.2 million) was higher than projected by $37.0 million, the only component that really had a strong showing was Act 154 revenues. As the months draw on, 154 cannot be expected to make up the slack in revenue from other line items especially corporations if the economy is not strong enough to meet projections. Moreover, the Commonwealth needs to move quickly to implement changes, such as the closing of schools and the consolidation of agencies, in order to realize meaningful savings from these measures. The fiscal year will be one-quarter gone by the end of September, and assuming the governor fails to execute (and expenses are distributed as in prior years), the Commonwealth could be as much as $390 million behind budget already. In this light, getting access to liquidity is a pressing concern; as we have highlighted previously, the Commonwealth s liquidity needs are acute in the coming year, and without a lifeline from either bondholders or banks, the first half of the year may prove difficult from a financing perspective. While we believe these incremental cash-flow funds should materialize, in our opinion, it is imperative that the Commonwealth secure additional near-term liquidity before the end of September. How much liquidity? While initial reports have indicated that the GO may receive as much as $1.6 billion in incremental liquidity from a proposed bridge financing from investors, $1.6 billion may prove smaller than expected if the current execution shortfalls remain. The Commonwealth may find itself more than $800 million behind budget by the end of December, and while much of this can be made up in the back half of the fiscal year, investors should not feel good about the inability of the Commonwealth to keep its fiscal promises. The governor has worked hard, however, to ensure that other deals should fix the budget going forward, and has secured deals with more than 60 percent of union employees to take payroll cuts of up to 6 percent in FY2015. The bet being made by investors, however, is that the FY2015 budget at least resembles balance, and with the disappointing first two months of the fiscal year behind us, the governor faces a massive uphill battle in this regard. If investors are willing to provide bridge financing, they should be leery of the black-box accounting areas of the budget education and health care where unrestrained spending could easily derail well-formed plans. Without greater oversight, the path of the budget can easily get out of hand, as it did in 2003, 2004, and 2005, when budget overruns from the health care and education systems resulted in massive upwards revisions (in excess of $300 million) in budget deficits for the fiscal year. A Calendar for PREPA. CRO Headlines New Era at Utility. PREPA s new world begins next week. According to the forbearance documents signed by PREPA s bondholders, the utility has until September 8 to name a Chief Restructuring Officer, and it is widely believed that this new officer will be closely associated with FTI Consulting, which has been assisting the GDB with liquidity analysis for public corporations in recent months. The naming of a restructuring officer is likely to be politically motivated, but investors should watch for a new officer to be named who is distinct and independent of the Garcia Padilla administration. The administration, which used the long weekend to wine-and-dine donors and union interests, has begun to turn the page on PREPA, having ring-fenced the entity. Since the utility has grown hugely unpopular, part of the PDP political strategy is to segregate PREPA s problems politically as well as financially; in short, if Utier is forced to absorb large payroll cuts, the governor wants to be clear that the other unions are safe and the PREPA restructuring is outside his administration. As such, a CRO who is distinct from the governor s administration

5 will be necessary; a truly independent CRO may have the added benefit of being acceptable to forbearing bondholders. Likewise, PREPA will now become the focus of significant financial scrutiny never before placed on any entity in PR. The new requirements are designed to indemnify investors against mismanagement by PREPA s leadership and help investors understand the severity of PREPA s financial condition. Among the items that PREPA will need to provide regularly are the following: Monthly report of cash balances Monthly breakdown of PREPA s bank statements Weekly statements of cash flow Weekly disbursements from PREPA s construction fund Copies of the engineer s report Details of significant signed contracts (greater than $50 million annually, including fuel suppliers) Additionally, PREPA will begin collecting on back accounts, and as of yesterday will use standard accounting for municipalities. PREPA will also record Cash in Lieu of Taxes (CILTs) as receivables on a gross basis. On the next page, we set out other important dates for bondholders.

6 Figure 5. PREPA Schedule Date Event Explanation September 1, 2014 September 1, 2014 PREPA Accounting Shift First Reserve Fund Installment PREPA begins recording revenue from municipalities and changes CILT procedures PREPA pays $34 million to a Reserve Fund special defeasance account; four more installments must be paid by January 1. September 8, 2014 CRO Appointment PREPA must have named a chief restructuring officer October 1, 2014 November 1, 2014 Second Reserve Fund Installment Third Reserve Fund Installment PREPA pays $34 million to a Reserve Fund special defeasance account in second installment PREPA pays $34 million to a Reserve Fund special defeasance account in third installment November 12, 2014 REAP Grants Close Applications for FY2015 Rural Energy for America (REAP) grants close November 15, 2014 November 27, 2014 November 27, 2014 November 27, 2014 December 1, 2014 December 15, 2014 FTI Report Due Comprehensive CILT Plan Interconnectedness Standards Effective Date Rate Review begins Fourth Reserve Fund Installment PREPA Long-Term Plan FTI Consulting must have submitted a report laying out best practices for operations at PREPA Comprehensive CILT plan must be effective PREPA must release standards for using its grid that meet IEEE Standard 1547 safety and performance standards. Net metering must be allowed as part of this transformation. PREPA must begin a comprehensive review of rates to determine what is fair and reasonable. It must ascertain where loss might be occurring and how future rate changes can be made more effectively PREPA pays the fourth $34 million installment to its Reserve Fund special defeasance account PREPA must have a five-year plan approved by bondholders and oversight board

7 December 15, 2014 January 1, 2015 January 1, 2015 January 15, 2015 March 2, 2015 March 31, 2015 April 1, 2015 May 27, 2015 July 1, 2015 July 1, 2015 July 1, 2017 July 1, 2017 January 1, 2018 January 1, 2019 FERC Releases Environmental Impact Statement Final Reserve Fund Installment PREPA Pays Bondholders Forbearance Review PREPA Finalizes Restructuring Plan Termination of Forbearance Agreement Projected Approval Date for Aguirre Rate Review Ends Integrated Resources Plan Due Energy Price at $0.22 per kwh High Efficiency Standards Energy Price at $0.20 per kwh Major Plant Conversion Complete Energy Price at $0.16 per kwh FERC EIS sets the clock ticking for approval of the Excelerate Aguirre Off-Shore regasification facility. PREPA pays the final $34 million installment to its Reserve Fund special defeasance account PREPA pays bondholders $214 million PREPA s forbearing bondholders can vote to terminate agreement after this date PREPA must have a finalized restructuring agreement in place PREPA s forbearance agreement with bondholders, the GDB, Scotiabank, and Citibank terminates While we do not know when / if FERC and other agencies will approval the facility, we believe a decision will come around this time. PREPA must have completed the rate review begun in November PREPA must submit a 20-year plan for meeting energy demand using current and planned infrastructure that reduces reliance on old technologies and increases the use of renewables in the system. The plan must set measurable yearly benchmarks for achievement. Per the existing capital plan. 60 percent of PRPEA s power generation must be from high efficiency sources. Per the existing capital plan. Per existing capital plan. Per the existing capital plan.

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