After devastating hurricanes in September 2017 shut down the island’s electricity grid, left thousands of residents homeless and destroyed schools, hospitals and businesses, Puerto Rico’s recovery has taken longer than had been hoped. And as foreign banks evaluate their presence on the island, its ability to attract much-needed investment is being hindered by a series of lawsuits related to its sovereign debt restructuring.
While federal aid and new initiatives may support Puerto Rico’s economy, resolving tensions with existing investors is a key priority to putting the island on the path to growth.
Banking boost
First, the good news. According to George Joyner, commissioner of the Office of Financial Institutions, the island’s financial regulator, Puerto Rico’s five principal banks enjoyed strong profits in 2018 and in the first quarter of 2019, and they have continued to maintain higher average common equity Tier 1 capital ratios than their US mainland peers, reflecting the island’s added risks, as well as healthy balance sheets.
Part of the reason for the latter, according to Mr Joyner, is that for several years all the banks exited their positions in central government and government-tied institutional debt, with the exception of Banco Popular, which still has a $460m exposure in some Puerto Rican municipalities. Non-performing loan ratios are also down to what they were before the hurricanes in nearly all banks’ loan portfolios, excluding loans for mortgages.
Ignacio Alvarez, president and chief executive of Banco Popular, Puerto Rico’s largest bank, says that in 2018 there were record sales of cars when residents received disaster-related insurance payments, and record sales of trucks due to reconstruction efforts. Banco Popular has about 56% of the market’s total assets and 49% of its loans, and bought Wells Fargo’s Puerto Rican auto loan business the same year.
Others are selling local operations, and while this is an opportunity for Puerto Rican banks seeking to expand, it also represents a worrying sign for the island’s banking sector and the economy in general.
In June 2019, Canada’s Scotiabank sold its local operations to Oriental Bank for $550m. This is an important deal for Oriental but marks the end of a long-standing commitment for Scotiabank. Oriental Bank will now become the island’s second largest bank by assets and it will acquire Scotiabank’s US Virgin Island branch operation for $10m as part of the deal. It had already taken over another foreign lender’s operations, BBVA’s banking, brokerage and insurance businesses, in 2012.
A sad goodbye
Scotiabank’s departure is a significant moment for Puerto Rican banking. It was the first non-US bank to establish a presence in Puerto Rico, in 1910, when the island had little more than a sugar economy. It had closed two branches on the island shortly after the hurricanes. In a statement to The Banker, the Canadian lender said the agreement completes a multi-year strategy of exiting 19 small jurisdictions, mostly in the Caribbean, and of focusing on larger countries where the bank can achieve a greater market share and sustainable profit growth.
With BBVA and now Scotiabank gone, the only remaining international bank with a wholesale and retail banking operation is Spain’s Banco Santander Puerto Rico. Earlier in 2019 there were unconfirmed reports of discussions between Santander and locally owned First Bank Puerto Rico. “The rumours were that what was involved was either a whole bank takeover or a takeover of a very significant part of [Santander’s operations],” says Banco Popular’s Mr Alvarez.
Banco Santander Puerto Rico declined to comment on a potential sale, but said in a statement that the bank’s strategy “has always been to adapt its business model to the economic challenges that Puerto Rico has been facing for years. We continue to focus on promoting organic and selective growth aligned with Puerto Rico’s risk profile, including the demographic challenges that the island is experiencing.”
Congress steps in
Puerto Rico has been trapped in an economic and demographic downward spiral for years. Since the 2008 financial crisis, its economy has shrunk by 20%, or $16bn, and its population has declined by 10% to about 2.8 million. Some 500,000 people have left the island since the latest hurricanes.
By 2016, with a shrinking tax base and after years of governments resorting to issuing debt to cover primary deficits, Puerto Rico had accumulated a staggering $73bn in financial debt and $50bn in unfunded pension liabilities, and was facing imminent default. The US Congress then stepped in and passed Promesa, the Puerto Rico Oversight Management and Economic Stability Act. Promesa imposed a full moratorium on all Puerto Rico debt payments and established a bipartisan Financial Oversight and Management Board with a mandate to restructure the debt, instil discipline in Puerto Rico’s finances and help the small territory back to health.
Throughout this period the aggregate balance sheets of banks in Puerto Rico steadily declined, in tandem with the reduction in commerce, apart from a modest growth in loan portfolios over the past year. “It is very difficult to have an improving economy with a decreasing population,” says Mr Joyner.
A battle ahead?
Meanwhile, a potential high-stakes battle is looming over the repayment terms of the oversight board’s latest debt adjustment framework agreement. The agreement could either quickly bring Puerto Rico back to capital markets or introduce greater uncertainty and prolong the island’s suffering by inviting litigation.
On June 16, the oversight board reached an agreement with holders of $3bn-worth of bonds. If the terms of such a deal were extended to the $35bn-worth of suitable bonds, this could lead to an average haircut of 60% on that debt and, therefore, a reduction of those obligations to $12bn over the course of the next 30 years. The deal would mean that the island could emerge from bankruptcy early in 2020.
Puerto Rico had already restructured its sales tax-backed bonds, known as Cofina bonds, in February, and it struck a deal in early June with the local pension body on $50bn of pension claims and with unions on collective bargaining and retirement. (The previously reported $55bn of pension claims part of the deal should be corrected to $50bn, according to the oversight board’s strategic adviser, Matthias Rieker.)
But the June 16 framework agreement poses specific and complex challenges. There are big differences in the suggested haircuts of certain bonds parts of the framework, which investors are unhappy about and which rely on a contested legal argument. As part of the $35bn restructuring, general obligation bonds – bonds that are paid out of general tax revenues – that were issued before 2012 would get a 36% haircut and bonds that have a constitutional guarantee on payments would get a 27% haircut. General obligation bonds issued since 2012, however, would suffer either a 55% or a 65% haircut because of a claim by the oversight board that $6bn of the general obligation debt that was issued since 2012 is invalid. This is because, they say, it exceeded Puerto Rico’s constitutionally established debt limits.
Reliable information?
The success of the framework agreement relies on the courts’ acceptance of those arguments, and such a prospect is worrying investors elsewhere in the US.
Kenneth Naehu, founder and managing director at Banyan Tree Asset Management in Los Angeles, who oversees about $1bn of municipal bonds, says what he finds most alarming is that the framework agreement would question the reliability of information provided to bond holders, which is a basic principle underlying the $3800bn US municipal market.
“What’s most appalling to everyone in the municipal market is that the oversight board can take the stance that information that was given to bond holders by Puerto Rico’s Government Development Bank – that information being inaccurate [about the debt ceiling] – is a basis if not for cancelling the debt then at least for trying to limit the recovery.”
James Spiotto, managing director of Chapman Strategic Advisors in New York and a municipal bankruptcy expert, says: “The problem is that [the oversight board] is breaking basic principles to achieve a reduction in the debt.”
Mr Naehu worries that the oversight board’s legal arguments for Puerto Rico might also set a dangerous precedent, especially when, he says, states such as Illinois and New Jersey and various US municipalities face the looming problem of potential large unfunded pension obligations.
But David Skeel, a member of the oversight board’s special claims committee, says that this is not the first time these issues have come up. Others say that so far there is no sign of the Puerto Rico case having a wider impact on the US market.
Lawsuits filed
The oversight board has also filed lawsuits against large investors holding at least $2.5m of the disputed bonds and against a group of financial institutions and a law firm that worked on those issuances, with the aim of recovering $1bn in fees and payments.
“The legal argument here is that as underwriters [the banks] aided and abetted the Government Development Bank of Puerto Rico’s issuance of this unconstitutional debt, and therefore payments made to them in connection with it, including all fees and profits, are fraudulent,” says Mr Skeel.
The group of defendants includes Santander Securities. Commenting on the allegations, Banco Santander US says: “We believe the claims asserted against Santander Securities LLC lack merit. This is a legacy issue related to the unprecedented decline in the Puerto Rico bond market [after 2012].”
Citigroup, Barclays and Bank of America, also part of the defendant group along with other large players, declined to comment.
The oversight board emphasises that neither lawsuit will proceed until the unconstitutionality of the $6bn bonds is validated in court.
Bankers, analysts and municipal bond experts are waiting to see whether the restructuring plan will lead to a quick resolution of Puerto Rico’s debt crisis, or whether negotiations with creditors will get bogged down in legal disputes and debt problems recur, as has happened in countries such as Ecuador and Argentina.
Long-term thinking
Another key question, raised by Mr Spiotto, is whether the oversight board’s estimated $83bn in post-hurricane relief and insurance payments due over time will be a springboard for improvements in infrastructure and sustained economic growth, or whether the economy will quickly deteriorate when the aid and insurance money runs out.
Attracting long-term investment will be crucial. Officials at Santander and Puerto Rico’s financial regulator believe that a new US Opportunity Zones initiative could bring in badly needed capital and create jobs in the key sectors of manufacturing and tourism.
Though the initiative is still in the process of being finalised by the US Treasury Department, much of the island qualifies. The condition for investors putting their unrealised capital gains tax-free into Opportunity Zones is that the zone must have at least a 20% poverty rate or a median family income lower than 80% of the statewide median. In Puerto Rico, more than 40% of the population lives below the poverty line.
With a number of foreign banks leaving the country, attracting fresh investments to Puerto Rico is all the more essential. Ongoing uncertainty over the completion of its debt restructuring efforts will hardly help.
