What choices do banks have when the going gets tough? Puerto Rico, a self-governing US territory, is burdened with a stagnant economy, low levels of tax collection and very high levels of debt. Indeed, only two US states – New York and California – have bigger debts, with Puerto Rico’s now standing at $72bn. Making matters worse, Puerto Rican bonds are widely held by US mutual funds and individual investors, so any default could be a real shock to the US municipal/sub-sovereign debt market.
And because of the territory’s unusual status as neither a sovereign country nor a state, its municipal entities also cannot invoke US bankruptcy laws and protections.
Meanwhile, a $655m payment on the principal and interest of the debt of the territory is due on July 1. The island’s state-owned electricity monopoly, known as Prepa, has a $400m payment on its $9bn debt due on the same day. Some market-watchers claim that it could struggle to meet this payment. To make matters worse, the administration of governor Alejandro Garcia Padilla – who assumed office in 2013 – has until June 30 to pass a new 2016 budget, or face the possibility of a partial government shutdown due to lack of funds.
As for the island’s banking sector, it is a measure of the intensity of the crisis in the country that since 2010, four commercial banks out of 10 active in the country, holding about one-third of the system’s deposits, have had to be taken over by the Federal Deposit Insurance Corporation (FDIC) of the US.
The resilience of the island’s surviving banks is significant, though. Rafael Blanco, commissioner of the Office of Financial Institutions (OCFI), Puerto Rico’s banking regulator, says several of these banks are pursuing a strategy of growing by acquisition as, in Puerto Rico’s stagnant economy, it is almost impossible to grow organically.
Banco Popular's growth plan
Banco Popular de Puerto Rico, the island’s oldest bank and its largest before the global financial crisis, has become even bigger since, as a result of two FDIC-assisted acquisitions (see charts 1 and 2).
The first, in April 2010, was of Westernbank de Puerto Rico, at the time the island’s third largest bank, which had 46 branches. Then, in February this year, Banco Popular – which generates up to 75% of its profits from operations in Puerto Rico and about 25% from operations on the US mainland – took over Doral Bank, which had $5.9bn in assets, from the FDIC.
Ricardo Carrion, Banco Popular’s president and chief executive, says that in the Doral transaction, Banco Popular obtained new branches in Miami and New York, a $1bn commercial loan platform in mainland US, and between $5bn and $6bn of additional mortgages in Puerto Rico.
On top of that, Banco Popular reached a separate agreement with First Bank, Puerto Rico’s second largest bank for loans, which also has operations in Florida and the Virgin Islands of the US, to take over 10 of Doral’s Puerto Rican branches.
Banco Popular’s acquisition strategy has paid off handsomely, according to Mr Carrion. The group became profitable again in 2011, and in 2014 it paid the US government back the $950m it provided the bank under the Troubled Asset Relief Programme.
“Our strategy continues to be to consolidate wherever we can in Puerto Rico, and take advantage of our economies of scale and the platforms we already have in place, so that if we acquire additional assets we can put them on our books with very little marginal cost,” says Mr Carrion.
Scotiabank's regional thinking
Meanwhile, Scotiabank de Puerto Rico, the oldest non-US bank on the island, also adopted an acquisition strategy in April 2010 when it reached an agreement with the FDIC to take over the troubled Puerto Rican based RG Premier Bank, which had $5.6bn in assets. Under the agreement, the FDIC guaranteed 80% of the losses on the vast majority of RG Premier Bank’s loans, which is a standard percentage of support in an FDIC bank sale.
Canada's Scotiabank, which has successfully increased its Puerto Rican market share in mortgages and car loans in recent years, has a smaller operation compared to locally owned banks. But in the Caribbean and Central America as a whole, Scotiabank is now a regional leader with operations in 27 countries, 550 branches and more than 2 million customers.
Oriental's new focus
Another Puerto Rican bank that has adapted an acquisition strategy is Oriental Bank – the holding company is OFG Bancorp – which, before the financial crisis, was just a small investment bank that did no lending beyond mortgages.
That narrow focus had its advantages, however. José Rafael Fernandez, president and chief executive of Oriental, says: “We stayed away from all the real estate construction lending problems that occurred in Puerto Rico back in those days. And we were very much focused on getting our team ready for what we felt was going to be a big wave of consolidation on the island, which started in 2010.”
It was then that Oriental took over Eurobank, a troubled commercial bank with $1.7bn in assets, in an FDIC-assisted transaction, which made it possible for the bank to move into retail banking. But one year later “we realised that we needed to do another acquisition, only this time there were fewer banks that could be acquired and they were healthy banks”, says Mr Fernandez.
So, after approaching Spanish banking giant BBVA, an agreement was struck in June 2012 to pay BBVA $500m for its Puerto Rican banking operations, which had about a 6% share of the loan market, as well as its local brokerage and insurance businesses.
From Oriental’s perspective, the deal was transformational. It catapulted the locally owned bank from about sixth place in assets in Puerto Rico to third place, and also gave it the island's second largest branch network, its largest car loan portfolio ($1bn), $1.7bn of residential mortgages and a commercial lending unit focused on small and medium-sized enterprises that holds the island’s second largest portfolio in that segment.
Efficiency drive
Another strategy being used by banks operating within the sluggish Puerto Rican economy is to make their operations more efficient, for instance, by introducing electronic banking and by being less dependent on more costly bricks-and-mortar branches.
An additional important cost-cutting change, much encouraged by regulators, is for banks to substantially reduce their dependence on US mainland wholesale funding and, in particular, the brokering of certificates of deposit, both of which are a much more volatile and expensive source of bank funding than customer deposits.
In December 2008, Puerto Rico’s banks’ wholesale deposits amounted to $28bn. In December 2014, this figure was down to $6bn, a 77% decline, according to the OCFI.
The decline is attributable in part to restructuring deals that took place in 2010. But the other side of the story is that banks have not found it necessary to boost their funding much because, alongside the prolonged economic contraction, loan demand has shrunk, from $62bn in 2008 to $42bn in December 2014, a drop of 33% according to OFCI figures. However, the banking system’s total deposits declined by 29% from $64bn to $46bn over the same six-year period.
“Banks have done a good job of reducing the cost of operations as much as they can. But it is hard to reach an equilibrium in terms of expenses and income when there is not good loan demand, and when [interest] rates are as low as they are the business portfolio is not going to give you much of a return, “ says the OFCI's Mr Blanco.
Mortgage delinquencies
The journey back to fiscal stability
Reaching a framework to bring stability to Puerto Rico after its fiscal crisis is a matter of urgency. And two developments are giving reasons for optimism. One is that Puerto Rico’s legislature approved a large sales tax increase recently, which is expected to generate $1.2bn in new revenue, and should help the island raise the money it needs to stave off a default.
The second is that the Puerto Rico Electric Power Authority, Prepa, has started negotiations with creditors to ensure it has sufficient liquidity to pay its debts, which amount to an additional $2.3bn in loans, according to one reported restructuring plan. The ongoing negotiations may help provide a blueprint for Puerto Rico restructuring the rest of its debt.
Puerto Rico's low interest rates, however, are spurring retail demand, at least for residential mortgages as customers re-finance their properties to lower the rate payments of their mortgages. At the end of 2014, residential mortgages were a large part of the banking sector’s business, accounting for an average 40% of total loans, according to OFCI.
But the downside is that Puerto Rico’s economy, which was hit by recession in 2006 – about one year before the US mainland – is still stagnant nine years later. Housing prices have come down and delinquencies on mortgages have shot up.
The average residential mortgage delinquency rate at the end of 2014 on the US mainland was 7%, according to the FDIC. But in Puerto Rico, the average was 14.68%, according to OFCI. The rate was 15.8% at the end of 2013, which marks an improvement, but it is still double the US rate.
Loan problems
Meanwhile, lending to car dealers and retail buyers, which can be a very profitable business, has been another growth market for banks on the island. But the delinquency rate for car lending of all types at the end of 2014 averaged 14%, about the same as the non-performing loan rate for mortgages, according to OFCI.
The delinquency rate for real estate construction loans, meanwhile, is still high, at about 30% according to OFCI figures. However, these loans are now a very small proportion of the banking sector’s total. Indeed, practically no construction lending is taking place in Puerto Rico, because there is a large inventory of unsold properties on the island and the absorption rate is very low.
Banco Popular and First Bank have managed to sell most of their past-due construction loans to hedge funds or written them off, according to Mr Blanco.
On the other hand, banks with a large exposure to Puerto Rican government bonds or to government-owned utilities, such as Prepa, are having to set aside more reserves for bad loans. Oriental, which has a $200m line of credit with Prepa inherited from its BBVA acquisition, set aside $24m in reserves against that loan in March this year, according to the bank’s statements.
Meanwhile the average return on equity (ROE) of banks in Puerto Rico was 7.39% at the end of 2014, the highest rate since 2006, according to OFCI figures.
A share buy-back strategy can help boost a bank’s earnings-per-share ratio as, among other things, it shrinks the number of shares a bank has on offer to the public. Some Puerto Rican banks have adopted this strategy recently, taking advantage of a situation that started in 2014 where the shares of Puerto Rican banks started trading near, or below, tangible book value.
Given the stagnant domestic market, expanding internationally is an option for Puerto Rico's lenders. Indeed, Oriental is the only commercial bank now operating in Puerto Rico that only has operations on the island. The lender is looking overseas but such a strategy is at an “early, planning stage”, according to Mr Fernandez.
Good health
An area where banks in Puerto Rico are healthy is their capital adequacy ratios. The average Tier 1 capital ratio on the island was 16.32% as of December 2014 according to OFCI, but that was before Basel III methodology came into effect this year.
Mr Blanco does not attach too much significance to this figure, however. "It is markets that really make or break a bank. A bank can have very high capital levels, but if it loses money every year then it will run out of money pretty soon,” he says.
So, will there be more bank consolidation in Puerto Rico? Bankers on the island think so, but not because of bank failures, as was the case in many such instances in the years after the crisis hit. If the Puerto Rican market – from a loan perspective and a banking perspective – continues to contract, then the next round of consolidation will be between healthy, well-capitalised banks.
