Fitch: Execution Risk the Near Term Concern for Puerto Rico; Court Ruling Less Significant

NEW YORK--()--Fitch Ratings believes that there are significant challenges ahead for Puerto Rico as it pursues initiatives necessary to maintain a credit profile commensurate with its 'BB-' general obligation (GO) rating. The next few months will be critical. Improving the Government Development Bank's (GDB) liquidity cushion, and therefore that of the commonwealth, is a key consideration. Fitch will look for a sizeable financing to be successfully brought to market. Fitch will closely follow revenue and spending performance in fiscal 2015 and the progress of the governor's new tax reform proposal and upcoming budget for fiscal 2016; failure to show continued progress toward structural balance would pressure the rating.

Fitch also will closely monitor developments for signs of any realignment of political and/or public sentiment that is detrimental to the interests of general government bondholders. In recent months the administration has struggled to secure workable legislative authorization for a refinancing of highway authority debt. The refinancing would provide needed liquidity for GDB. Fitch has also noted discussion in the media advocating broad debt restructuring. To the extent this proves to be a sign of deteriorating support for measures supportive of credit quality, it is negative for the commonwealth's general obligation and related credits.

Fitch continues to believe that the ultimate success of efforts to put the commonwealth's finances on a sustainable path will be driven by the performance of the economy; however, in the near term Fitch judges the execution risks discussed above to be the more immediate concern. The Negative Outlook that Fitch assigned to the 'BB-' rating in July 2014 reflects both continued economic weakness and the significant implementation risks to achieving budget balance.

Last week's federal court ruling that found this summer's restructuring law unconstitutional has no effect on Fitch's ratings of the Puerto Rico Electric Power Authority (PREPA; rated 'CC', Watch Negative), the Puerto Rico Aqueduct and Sewer Authority (PRASA; rated 'B+', Watch Negative), or the commonwealth's general credit (rated 'BB-', Outlook Negative), although it does create additional uncertainty about the path forward for public corporations.

DELAY IN PRIFA FINANCING STRAINS LIQUIDITY

The GDB's liquidity has been falling and an infusion of cash is important to the stability of both the bank and the commonwealth. As GDB currently has sizable loans outstanding to the Highways and Transportation Authority, a refinancing of this debt would meaningfully bolster liquidity. To this end, last month the governor signed legislation that increases petroleum taxes to support a Puerto Rico Infrastructure Finance Authority (PRIFA) financing of up to $2.95 billion that would be used, in part, to pay off the highway authority loans at GDB.

On the downside, the package took much longer than expected to make its way to enactment and, of more concern, included provisions that would make it challenging to execute the financing. Specifically, a cap on the maximum borrowing cost that the commonwealth could accept was a significant limitation. The legislature reportedly now has loosened the restriction by eliminating the maximum discount on the bonds while retaining the average coupon rate cap at 8.5%, which supports the viability of the financing.

Given the commonwealth's very tight fiscal position, GDB liquidity in essence serves as the financial cushion for the general fund. The commonwealth's general fund revenues are 2.5% ($96 million) below forecast through the first half of the year, with expenditures reportedly in line with forecast. Sixty percent of annual general fund revenues are projected to come in during the second half of the year, with 36% of the annual total from April through June when the ability to take offsetting action is limited. As a result, the cushion provided by GDB is particularly important and significant to Fitch's assessment of overall commonwealth credit quality.

Fitch has recognized the repeatedly demonstrated focus of the current administration on bolstering the fundamentals of its general credit, and the legislature has consistently approved very difficult measures in recent years, including pension reform and budget balancing on the revenue and spending side of the equation. However, challenges in recent months suggest a higher level of pushback from the legislature is a possibility going forward.

MARKET ACCESS KEY

Puerto Rico has become increasingly reliant on markets other than traditional municipal investors for external financing. The commonwealth still appears to have sufficient access to funding from such sources as long as it is willing to pay the elevated rates and agree to the terms that this base demands.

To the extent that the commonwealth confronts limits to market access, Fitch expects that it would prioritize the PRIFA financing due to its interest in improving the GDB's liquidity position. In addition, the refinancing of the highway authority debt reportedly may benefit from participation by bond insurers that have existing exposure to the credit, although this remains uncertain.

EXTENSIVE TAX CODE REFORM PROPOSED

Last night, the governor announced his proposal to substantially reshape the commonwealth's tax code. Consistent with expectations, the plan is to focus taxation on consumption by imposing a value-added tax designed to both generate substantial additional revenues, including by reducing tax evasion, and support economic growth. At the same time, the governor would reduce income tax rates, eliminate the unpopular gross receipts tax, and include reimbursements for lower income levels.

The commonwealth's above-average reliance on corporate taxes has been a credit negative, given the potential volatility and concentration inherent in these revenue streams, and a substantial revision to the revenue system has been anticipated. Nevertheless, the tax plan too involves substantial risks in both passage and during the implementation period, which may extend over multiple years.

NO RATING IMPACT OF FEDERAL COURT REJECTION OF RECOVERY ACT

On Friday, a federal district court judge found the Puerto Rico Public Corporation Debt Enforcement and Recovery Act unconstitutional. This has no effect on Fitch's ratings on PREPA and PRASA, which were both subject to the Act, because Fitch's tax-supported ratings consider an obligation's relative vulnerability to default and do not incorporate any measure of recovery after default. Although investors' recovery prospects are likely improved following the court decision, Fitch does not consider the likelihood of default to be materially changed as a result.

The impact of the court decision on Fitch's assessment of Puerto Rico's general credit is likewise muted. The Recovery Act, which established a restructuring regime for public corporations that may become insolvent, was an effort to fill the void resulting from the absence of a federal bankruptcy alternative in Puerto Rico. Although the commonwealth showed a willingness to change law to the detriment of bondholders with passage of the Act, a negative credit consideration, the stated intent was to provide a path to restore solvency of public corporations and thereby strengthen the general credit. The Act specifically excluded the commonwealth's GO debt and certain instrumentalities of the commonwealth, including the Puerto Rico Sales Tax Financing Corporation (COFINA).

Given the economic and fiscal pressures facing the commonwealth, Fitch does not expect it to provide any meaningful financial support to its public corporations going forward. As such, any risk that the decision presents to the central government is indirect. If investor reaction to the ruling were to have a material negative effect on market access, which Fitch does not currently anticipate, it could complicate the ability to secure needed additional liquidity for the GDB in the near term. Similarly, any negative economic effect of the decision would be detrimental to the commonwealth, but that seems unlikely at this point.

The judge's decision reportedly will be appealed, but Fitch expects the process to be protracted and uncertainty to linger. In this environment, Fitch believes that extending Chapter 9 provisions to the commonwealth to provide a framework for orderly debt restructuring would offer some benefits.

Puerto Rico's Resident Commissioner and Congressional representative is once again proposing to amend the U.S. bankruptcy code and extend to Puerto Rico the power to use Chapter 9 proceedings in federal bankruptcy court to adjust debts of its municipalities and public instrumentalities. From a bankruptcy standpoint, the amendment would place Puerto Rico on an equal footing with the 50 states, who can currently use Chapter 9 to achieve debt adjustment for their municipalities. Although the amendment failed to gain traction in Congress last year, current circumstances may improve its prospects. Fitch would expect the Recovery Act and related appeal to become moot if Chapter 9 were to become available.

PUBLIC CORPORATIONS FACE DECISION POINTS

In addition to the significant upcoming events related to the commonwealth's general government operations, both PREPA and PRASA will confront important decision points in the coming weeks.

Fitch's 'CC' (Negative Watch) rating on PREPA's power revenue bonds reflects our belief that a restructuring of the authority's debt obligations remains probable despite existing forbearance agreements between the authority and certain of its creditors (including bondholders). The forbearance agreements extend through March 31, 2015, although the terms allow for termination of the agreements after Jan. 15, 2015 at the option of the forbearing banks, or 25% of the forbearing bondholders, and the authority is reportedly seeking an extension to June. The authority has retained a chief restructuring officer and the forbearance agreements require submission of a restructuring plan by March 2, 2015.

The Negative Watch on PRASA's 'B+' rating reflects concerns relating to liquidity requirements that are dependent on third-party extension of credit or market access. PRASA has certain bank lines of credit outstanding that mature in March 2015. Difficulty or perceived inability to refinance or extend the outstanding bank LOCs and access funds for its capital improvement plan would put negative pressure on PRASA's rating.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria and Related Research:

--'Fitch Maintains Watch Negative on Puerto Rico Aqueduct and Sewer Authority Senior Revs' (Jan. 7, 2015);

--'Fitch Maintains Puerto Rico Electric Power Auth's Rev Bonds on Negative Watch' (Dec. 11, 2014);

--'Fitch: Chapter 9 Extension Would Be a Positive for Puerto Rico' (Aug. 6, 2014);

--'Fitch Downgrades Puerto Rico GO, Sales Tax, Retirement System & Water Revenue Bonds' (July 9, 2014);

--'Commonwealth of Puerto Rico' Full Rating Report (March 10, 2014);

--'U.S. State Government Tax-Supported Rating Criteria' (Aug. 14, 2012).

Applicable Criteria and Related Research:

Commonwealth of Puerto Rico

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=737975

U.S. State Government Tax-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=686033

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Contacts

Fitch Ratings
Laura Porter
Managing Director
+1-212-908-0575
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Karen Krop
Senior Director
+1-212-908-0661
or
Dennis M. Pidherny (PREPA)
Managing Director
+1-212-908-0738
or
Doug Scott (PRASA)
Managing Director
+1-512-215-3725
or
Media Relations:
Elizabeth Fogerty, New York, +1 212-908-0526
Email: elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Laura Porter
Managing Director
+1-212-908-0575
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Karen Krop
Senior Director
+1-212-908-0661
or
Dennis M. Pidherny (PREPA)
Managing Director
+1-212-908-0738
or
Doug Scott (PRASA)
Managing Director
+1-512-215-3725
or
Media Relations:
Elizabeth Fogerty, New York, +1 212-908-0526
Email: elizabeth.fogerty@fitchratings.com