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WASMER, SCHROEDER & COMPANY
INVESTMENT ADVISORS
PuertoRico:
GreeceoftheWest?
November
2011
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PUERTORICO:GREECEOFTHEWEST?
600FifthAvenueSouth,Suite210 Naples,FL34102 [T]239.263.6877 [F]239.263.81462
WASMERSCHROEDER.COM
PUERTORICO:THEGREECEOFTHEWEST?Overthepastyear,municipalcreditqualityhascome
underfirewithanumberofpeople,mostnotably
MeredithWhitney,callingforlargeincreasesin
municipalbonddefaults. As2011hasmarchedon,we
haveactuallyseenfewerdefaultsthan2010with
numbersnotclosetothehundredsofbillionsthat
Whitneyforetoldina60Minutesnewsreport. The
questionremainsthough,Willweseeanuptickindefaultsforvulnerablecredits? Aswehavearticulated
innumerous
pieces
over
the
past
year,
Wasmer,
Schroeder
&
Company
has
not
believed
there
would
be
a
rashofdefaultsinthemunicipalsectorin2011andwemaintainthatoutlook. Wedobelieve,however,that
troubleispotentiallyonthehorizonforonewidelyownedcreditinparticular,anditssimilaritiestomanyof
theweakerEuropeannationsareworthnoting. ThiscreditistheCommonwealthofPuertoRico. Whilewe
donotbelievethatdefaultisimminent,thepotentialdoesexistthatPuertoRicodigsafinancialholesodeep
thatthereremainsnowaytogetout. WhileourseparatelymanagedaccountshavenoexposuretoPuerto
Ricogeneralobligation(GO)bondsoritspubliccorporations(otherthanthosewhichareprerefundedor
escrowedinUSGovernmentsecurities),wedobelievethatthewidespreadownershipofPuertoRicos
bonds,thelargeamountofdebtoutstandinganditshighprofilestatuscouldhavefarreachingimplications
forthemunicipalmarketasawholeifPuertoRicowereexposedtoanyseverefiscalstress.
HISTORYPuertoRico,meaningrichport,wasfirstclaimedbyChristopherColumbusforSpainin1493andforover
400yearswasacolony/territoryofSpain. In1898,duringtheSpanishAmericanWar,PuertoRicowas
invadedbytheUSandwascededtotheUSundertheTreatyofParis. In1917PuertoRicansweremadeUS
citizensandin1947theUSgrantedPuertoRicothepowertoelectitsowngovernor. PuertoRicoisofficially
anunincorporatedterritoryoftheUS. ThismeansthatUSFederallawappliestoPuertoRicodespite
havingnovotingrepresentationinCongress.ThePuertoRicanconstitutiondeclaresthattheyarea
CommonwealthoftheUS. ThisrequirescitizenstopayFederaltaxesincludingSocialSecurityandMedicare
taxes,aswellasimport/exporttaxesandfederalcommoditytaxes. ResidentsofPuertoRicoarenot
residentsofastateortheDistrictofColumbiaandthereforearenotqualifiedtovoteinFederalelections1.
AnothermajordifferencebetweenPuertoRicoandthestatesisthefactthatthepopulacemayvoteto
dissolvetheir
Commonwealth
status,
and
unlike
US
states,
this
vote
would
not
require
the
approval
of
the
US
Congressorstateratificationtodoso. Whilearemoterisk,itisoneuniquetoPuertoRicoandbears
considerationbybondholders. Additionally,andmostimportantlyformunicipalbondinvestors,interest
incomeproducedbyPuertoRicosbondissuesistaxexemptattheFederal,stateandlocallevelinanystate
intheUS,thusmakingthemdesirableforthoselivinginhightaxlocales.
1www.topuertorico.org
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PUERTORICO:GREECEOFTHEWEST?
600FifthAvenueSouth,Suite210 Naples,FL34102 [T]239.263.6877 [F]239.263.81463
WASMERSCHROEDER.COM
CURRENTECONOMYPuertoRicoseconomyislargelydominatedbythegovernmentandtourismwithmanufacturingandtrade
accountingforsignificantportionsoftheeconomyaswell. PuertoRicohashistoricallybeenapoorterritory
in
relation
to
US
states;
over
44%
2
(compared
to
15%
in
the
US
3
)
of
the
population
lives
below
the
federal
povertyline. Thisrampantpovertyhasalsocontributedtoanextremelyhighcrimeratewith22.54murders
per100,000people,worsethananyUSstate. PuertoRicowasexperiencinganeconomicslowdowneven
beforethe2008financialcrisisoccurredandtheireconomicwoeswereexacerbatedbytheweakdemand
comingfromtheUSandtherestoftheworldintheaftermathof2008.Priortothecurrentgovernors
tenure,fiscaldisciplinewasoftenignoredandlargebudgetdeficitswerethenorm,risingto$3.3billion5in
2009(2001wasthelastyearwithabudgetsurplus). Thevastmajorityofdeficitswerefinancedwith
borrowingasopposedtoaneffortofcuttingcosts,especiallywiththecreationofCOFINAbonds6 which
arebackedbysalestaxrevenuesandeffectivelysubordinateGObondholdersthroughthisnewstructure. As
thetablebelowshows,debthasconsistentlygrownoverthepastseveralyearsbyutilizingnonGOavenues
toraisecapital. Whilethishasallowedlowerborrowingcosts,thepledgingofrevenuestreamsconstrains
budgetflexibilityinthefuture.
ITEM DECEMBER08 DECEMBER09 DECEMBER10 $DIFFERENCE(20102008)
CentralGovernmentTotal 14,228 13,208 12,782 (1,446)
Constitutional 9,006 9,511 9,193 187
TRANSsandTRABs 2,500 900 900 (1,600)
Extraconstitutional 2,721 2,797 2,689 (32)
COFINA(net) 6,306 11,544 14,218 7,912
PublicCorporationsTotal 26,596 27,358 28,195 1,599
PRASA 2,827 3,144 3,473 646
PREPA 6,031 5,858 7,781 1,750
PRHTA 6,344 6,240 6,120 (224)
PRRBA 3,124 3,300 3,324 200
PRIFA 1,853 1,828 1,798 (55)
PRPA
59 56 46
(13)
OtherandDebtswithDGBandPrivate 6,358 6,932 5,653 (705)
Municipalities 2,838 3,139 3,331 493
DebtnotsupportedbyGeneralFund 6,489 5,407 5,358 (1,131)
Debt,GrandTotal 56,455 60,656 63,884 7,429Source:GovernmentDevelopmentBankforPuertoRico
2www.topuertorico.org
3USCensusBureau
4AssociatedPress
5OfficeofManagementandBudget
6COFINAistheSpanishacronymforthePuertoRicoSalesTaxFinancingCorporation,anindependentinstrumentality
oftheGovernmentofPuertoRicocreatedin2006
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PUERTORICO:GREECEOFTHEWEST?
600FifthAvenueSouth,Suite210 Naples,FL34102 [T]239.263.6877 [F]239.263.81464
WASMERSCHROEDER.COM
TheeconomyofPuertoRicoremainsweakandadropinGross
DomesticProduct(GDP)isexpectedforthecurrentfiscalyear.
Unemployment,despitefallingfromitshighs,isstillatacrippling
15.4%as
of
September
2011
and
the
labor
participation
rate
of
40%
isfarbelowtheUSaverageof64%. Thevalueofconstruction
permitshasfallenapproximately23%yearoveryear,althoughtrade
andtourismhavereboundedwithgrowthof5.2%and17.8%year
overyear,respectively. Mosttroubling,andofgreatimportanceto
thegovernmentsfinances,aretheunfundedpensionliabilitiesof
PuertoRico. Forfiscalyear2010,thetwolargestgovernment
pensionplans,PublicEmployeesandTeachers,werefundedat8.5%
and23.9%,respectively;whereastheaverageUSstatesfunding
ratiois75%. Thegovernmenthasputplansinplacetohelpeasethis
burdenbyconvertingtoadefinedcontributionplan,increasingthe
employer
contribution
rate
every
year
for
the
next
ten
years
and
reducinggovernmentpayrollnumbers. Despitethesechanges,itis
stillestimatedthatthepensionfundswillbecomeinsolventasearly
as2019. Outstandingpublicdebthasincreasedby9%peryearover
thepasttenyears,fargreaterthantheCommonwealthsrateof
growth. Debtservicecostsremainamanageable6.5%of
expendituresbutmuchoftheCommonwealthsdebtisbackend
loaded,puttingagreaterburdenonfuturegenerations.7,8,9
Onthepositiveside,GovernorLuis
Fortuohasmadeitagoaltogetthe
Commonwealthsfiscalhouseinorder.He
hasimplemented
anumber
of
permanent
andtemporarytaxincreases. Hehasalso
cutgovernmentexpensesandpayrollover
thepasttwoyearsby19%and16%,
respectively10. Ahiringfreezeacrossall
agencieshasbeenimplementedasthe
governmentpayrollofPuertoRicois
notoriouslybloatedandaccountsfor
approximately30%ofPuertoRicosentire
payroll. Whilethegovernorexpectsto
achieveabalancedbudgetin2013and
createarainy
day
fund
by
2014,
slower
thanexpectedgrowthand/orpolitical
considerations(includingthefactthat
GovernorFortuoistrailinghismore
liberalchallengerinrecentpolls),could
7OfficeofManagementandBudget
8BureauofLaborStatistics
9GovernmentDevelopmentBankforPuertoRico
10OfficeofManagementandBudget
29%
3%
16%
5%
33%
4%5%
4%
PAYROLL EMPLOYMENTSource:GovernmentDevelopmentBankforPuertoRico,asof11/9/2011
Government
Contruction&Mining
Trade
Finance,Insurance&RealEst
Services
Manufacturing DurableGoo
Manufacturing Nondurable
Other
0% 3% 6% 9% 12% 15% 18%
QatarGhana
Mongolia
Eritrea
Ethiopia
China
India
Usbekistan
TimorLeste
Laos
GDPGROWTH FORECSTS,2011
FastestTen
5% 4% 3% 2% 1% 0% 1%
SpainBahamas
Iceland
Italy
Venezuela
Ireland
Barbados
Portugal
Greece
PuertoRico
SlowestTen
Source:TheEconomist
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PUERTORICO:GREECEOFTHEWEST?
600FifthAvenueSouth,Suite210 Naples,FL34102 [T]239.263.6877 [F]239.263.81465
WASMERSCHROEDER.COM
derailsomeofthefiscalconservatismdemonstratedbythecurrentadministration. Debtburden
continuestoriseanduntilthisbeginstodroportheeconomybeginstogrowfasterthantheriseindebt,
theCommonwealthofPuertoRicoisheadingforapossiblefiscaltippingpoint.
COMPARISONTOTHEPORTUGAL,IRELAND,ITALY,GREECE,SPAIN(PIIGS)
While2008wasallabouttheproblemsintheUSanditsbankingsystem,2011hasbeencharacterizedbythe
EuropeanUnion(EU)anditsbanks. WhiletheEUstruggleswithhowtocreateanorderlydefaultinGreece
andinvestorsremainskepticalastowhetherotherEUnationssuchasItalyandSpainwillbeabletoescape
massivedebtrepudiation,weseesimilaritiesbetweentheseweakEUcountriesandPuertoRico. Asthetable
belowillustrates,PuertoRicoseconomicanddebtstatisticsarefarmoregrimthanthemostleveragedstates
intheUSbutareapproachinglevelsseeninthePIIGS.
Debtto
GDP/GSP
DebtPer
Capita
Unemployment
Rate(%)
PerCapita
Income
Debtto
IncomeRatio
PuertoRico* 31% $7,837 15.40% $13,675 57.3%
Massachusetts
8%
$4,606
7.30%
$51,302
9.0%
Hawaii 8% $3,996 6.40% $41,661 9.6%
Connecticut 8% $4,859 8.90% $54,877 8.8%
NewJersey 7% $3,669 9.20% $51,167 7.2%
Greece 166% $34,103 12.60% $27,360 124.6%
Portugal 106% $16,402 11.00% $24,710 66.4%
Ireland 109% $35,122 13.70% $32,740 107.3%
Italy 121% $38,025 8.40% $31,090 122.3%
Spain 67% $17,539 20.10% $31,550 55.6%
*DoesnotincludePublicCorporationswhichhaveanadditional$28blnindebt
Sources:DeutscheBank,StateofConnecticutGeneralAssembly,BureauofLaborStatistics,BureauofBusiness&EconomicResearchattheUniversityofNewMexico,EuropeanCommission,TheEconomist,WorldBank
Structurally,PuertoRicohasmanysimilaritiestotheseEuropeannationsincluding,butnotlimitedto,a
bloatedgovernmentworkforce,largeunfundedpensions,extremelyhighunemploymentrates,largedebt
levelsasapercentageofincomeorGDP,andweaktaxcollections. Whilenoneofthesemetricsisatthe
pointtolimitPuertoRicosabilitytoborrowinthefinancialmarkets,thepossibilityexiststhattheircurrent
trajectorycouldleadtoacrisisofEuropeanproportions. Continuedgovernmentjobcutswhicharenot
offsetbyprivatepayrollgrowthandreducedbenefitscouldleadtounrestsimilartowhathasbeenseenin
Europe. ProceedsofPuertoRicosborrowingarebeingusedtopaypreviousdebtsasopposedtobuilding
infrastructureorcreatingeconomicgrowth. Ofthecloseto$8billioninCOFINAborrowingsin200910,94%
wasutilizedtopayexistingdebtsanddealwithdeficits.MunicipalborrowinginPuertoRicoiscloseto$64
billionasof2010. WhilenotallisdirectlytiedtothegovernmentofPuertoRico,thevastmajorityofthis
debthas
some
connection.
Based
on
this
metric,
debt
per
capita
is
awhopping
$17,265
which
is
more
than
thatofPortugal,closetothatofSpain,andwellabovePuertoRicoslowpercapitaincome11.
Despitehavingafiscallyconservativegovernor,thehistoryofPuertoRicoisonelitteredwithcronyismand
irresponsiblefiscalchoices. Furthermore,PuertoRicoremainsanextremelyimpoverishedterritoryand
growthprospectsremaindim. WhilethesimilaritiesbetweenthePIIGSandPuertoRicoareglaring,itis
importanttonotethatimportantdifferencesdoexist,mostnotablythefactthatthebankingsystemin
PuertoRicoisnotthreatenedatthecurrenttime. ManyUSbankshaveoperationsinPuertoRicoandthe
11GovernmentDevelopmentBankforPuertoRico
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PUERTORICO:GREECEOFTHEWEST?
600FifthAvenueSouth,Suite210 Naples,FL34102 [T]239.263.6877 [F]239.263.81466
WASMERSCHROEDER.COM
GovernmentDevelopmentBankcontinuestoexpanditsbalancesheetandmanageliabilitiesreasonablywell.
Also,atleastcurrently,thereisnodesireamonginvestorstoshedPuertoRicodebtandtheirupcomingdebt
maturitiesremainmanageablewithouttheballoontypepaymentsweseeinmanyEuropeannationsand
someareasofthecorporatebondmarket. Stillthetrajectoryremainstroubling;ifPuertoRicosfiscal
problemsarenotaggressivelydealtwithbytheendofthecurrentdecade,themunicipalmarketcouldbe
facedwithasignificantcredithurdle.
CONCLUSIONManyinvestorsarecomfortableholdingPuertoRicodebtdespitetheirlowratings(whicharemostlyinthe
BBBandAcategories)becauseofthebeliefthatiftheygotintoseverefiscaltroubletheUSCongressmay
bailthemout. AsaCommonwealththeyhavenoaccesstomunicipalbankruptcyandthereisnoimplicitor
explicitguaranteeofthedebtbytheUSgovernment. DoesthismeanthatCongresswouldnotcometotheir
aid? Notnecessarily,butinanincreasinglycontentiouspoliticalenvironmentwithfiscalconservatism
runningrampant,theoddsofabailoutseemfarlesslikelythanafewyearsago.Additionally,aswehave
seenwithJeffersonCounty,ALandHarrisburg,PA,localpoliticscanplayanimportantroleinthewillingness
ofgovernments
to
pay.
PuertoRicosgrowingdebtburdenandpensionliabilitiesmaybecomesolargethatnoactionbesides
restructuringcanbetakentoresolvetheirfiscalissues. WehopethatPuertoRicocontinuesonitspathto
fiscalresponsibilitybutarekeenlyawareoftherisks,botheconomicallyandpolitically,toPuertoRicobonds
andtheircreditratingsifthingsdonotimprovemateriallyandquickly.
Disclaimer:Thematerialprovidedisforinformationalpurposesonlyandcontainsnoinvestmentadviceorrecommendationstobuyorsellany
specificsecurities.ThestatementscontainedhereinarebasedupontheopinionsofWasmer,Schroeder&Company,Inc.(WSC),thedata
availableatthetimeofthepresentationwhichmaybesubjecttochangedependingoncurrentmarketconditions. Thispresentationdoesnot
purporttobeacompleteoverviewofthetopicstated,norisitintendedtobeacompletediscussionoranalysisofthetopicorsecurities
discussed. Allopinionsandviewsconstituteourjudgmentsasofthedateofwritingandaresubjecttochangeatanytimewithoutnotice.WSC
doesnotacceptanyliabilityforanylossordamagearisingoutoftheuseofalloranypartofthispresentation.Thisreportshouldnotbe
regardedbyrecipientsasasubstitutefortheexerciseoftheirownjudgmentandmaycontainnumerousassumptions.Differentassumptions
couldresultinmateriallydifferentoutcomes. PleasecontactWasmer,Schroeder&Companyformorecompleteinformation,includingthe
implicationsandappropriatenessofthestrategyorsecuritiesdiscussedhereinforanyparticularportfolioorclient.
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headquartersareinNaples,Florida,wherethetaxexemptPortfolioManagementteam,ClientServices,Operations,IT,Accounting,Compliance,
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