The first shoe has dropped. Last night, Standard & Poor’s ended months of market speculation by finally downgrading the Commonwealth of Puerto Rico’s G.O. debt from BBB- to BB+, i.e. below investment-grade. The GDB’s rating was also cut to BB. Both ratings remain on Negative CreditWatch, signaling that further downgrades are possible.

While S&P was the first one out of the gate, in my opinion, it’s now only a matter of time before the other two rating agencies follow suit. In a way, a new chapter in the Puerto Rico muni saga has just begun.

As recently as yesterday afternoon, according to our sources on the ground, the GDB had been leaning on the PR Judicial Branch to pass the Teachers Retirement System reform proposal in order to help prevent a downgrade, claiming that such downgrade may result in massive government layoffs and skyrocketing interest rates. For the GDB to cross constitutional lines and pressure the judiciary in such a way was clear evidence of its desperation.

S&P’s decision came after months of frantic efforts by the Padilla Administration to do everything in its power to placate the rating agencies. Commonwealth officials tried to shore up liquidity at the GDB by pulling in deposits from local banks. They touted improved revenue collections and highlighted economic development initiatives. Earlier this week, after meeting with the rating agencies in New York, they thought they could still delay the inevitable by announcing a balanced budget proposal for fiscal 2015, one year ahead of previous forecasts.

… once we get past the initial media hysteria, the downgrade may turn out to be largely a non-event.

Unfortunately, as well-meaning as those actions were, they also rang hollow; in the absence of full disclosure about the GDB’s true cash flows, efforts to bolster the Bank’s liquidity only made the market more suspicious of its true condition. Even the balanced budget proposal came too late. As we told the Bond Buyer, if the Commonwealth now believes it can eliminate deficit financing through cost-cutting measures and without the need for more government layoffs, why did it wait so long to accomplish this? No wonder market participants shrugged off this latest move as mere “window dressing” ahead of the new bond financing.

Regular readers of our column know we’ve been harping constantly on the lack of transparency at the GDB. When S&P put the Commonwealth on CreditWatch on January 24th, we noted that the agency had explicitly called out the GDB’s liquidity position as a key issue. As it turns out, concerns about short-term liquidity were, in fact, behind S&P’s move yesterday. According to David Hitchcock, S&P’s lead analyst, after seeing the GDB’s cash flow statements and liquidity position, the agency had no choice but to act quickly. In a way, the market’s suspicion about the GDB’s tenuous liquidity position has been all but confirmed.

At this point, PR officials probably feel they just can’t win, and who can blame them? They just can’t win because this downgrade should have occurred months ago. By dragging their feet and setting up all kinds of new credit hurdles to justify their actions, the rating agencies have probably contributed to the uncertainty surrounding PR’s bonds. The market, on the other hand, has already rendered its verdict months ago, pushing PR G.O. yields to what we believe is the equivalent of a “B” G.O. credit.

There may be a silver lining to all this. We believe a downgrade to speculative status may already be fully discounted by the market. In fact, once we get past the initial media hysteria, the downgrade may turn out to be largely a non-event. Any institutional account that may be forced to sell has probably already done so by now. Having managed a couple of mutual funds in my time, I can attest that many funds have loopholes in their prospectuses that may allow them to continue to hold bonds that have been downgraded to junk, particularly to avoid forced selling into unfavorable market conditions. Others can hold bonds that are split-rated between junk and investment grade, so they may only need one out of the three rating agencies to maintain an “investment grade” rating. Still others have had plenty of time to ask their Board of Trustees for special permission to hold the debt in order to avoid a fire sale. The point is: previous forecasts of further massive liquidations of PR bonds may prove grossly exaggerated.

Note that we said “further liquidations.” In our view, much of the “systemic risk” related to PR may already have occurred: for proof, just look at the massive mutual fund liquidations we witnessed last year, particularly out of those institutions that were over-weighted in PR paper. Who knows? The bulk of the predicted “forced selling” may already have occurred.

To underscore the growing irrelevance of the ratings, Standard & Poor’s very own Dow Jones Indices group last Friday removed Puerto Rico bonds from its S&P National AMT-Free Municipal Bond Index, saying the bonds are now trading at high-yield corporate levels, have inconsistent liquidity characteristics and thus no longer “meet the objective established by this investable investment grade index.” Yes, even the Index team at S&P saw the oncoming lights of the downgrade train.

That said, we certainly don’t want to downplay the symbolic and, more importantly, the technical implications of a downgrade to junk status. Capital charges to the bond insurers for their PR exposure would certainly rise, undermining their ability to do other business. Collateral requirements for some of the Commonwealths swap transactions may also increase and could add up to as much as $1 billion, according to a recent Moody’s report. Last but not least, those institutional investors whose performance is predicated on muni market indices (the ETFs for example) will have to deal with a significant shift in the composition of their indices, as a significant portion of the market will transition from investment grade to high yield status.

So what does this all mean for PR’s “market access,” going forward?

After balking at what they perceived as usurious rates back in the fall, PR officials appear to have resigned themselves to paying whatever it takes to get a financing done. Confirming an earlier report from the New York Times, the Wall Street Journal (WSJ) reported this week that the Commonwealth is in fact cobbling together a $2 billion deal from various sources, including hedge funds.

This time around, the Commonwealth isn’t exactly negotiating from a position of strength. According to the WSJ, Morgan Stanley’s earlier proposal reportedly carried an interest rate of 10%. Other private financing offers would allow creditors to sue the Commonwealth in New York State rather than local court in the event of default. (Note: see one major legal firm’s view on the jurisdictional issues). Still others would require a non-callability feature to allow investors to lock in these high yields until the bonds mature.

Bringing a deal to market at any price does have ancillary implications: it may lead to a market-wide revaluation of all existing PR debt. If the “best-secured” debt in the capital structure is yielding say 10% or more, what would the rest of the PR debt be worth? The pricing services should have a field day trying to figure this out. The lower-coupon debt in particular, with 4.00 or 5.00% coupons, may see a sharp downward adjustment in dollar price. Needless to say, existing bondholders stand to get hurt even more, at least from a mark-to-market standpoint. In the capital markets, nothing happens in a vacuum and everything is related.

Faced with such equally unpalatable options, we suspect the Commonwealth will have no choice but to go back to its best financing vehicle, the Cofina bonds, even if it may have to pay upwards of 9.00% for a third lien structure. At least, some degree of financing flexibility will be preserved by going through Cofina.

Yet, even a successful deal would not resolve anything. It would only buy the government some more time to bring the economy out of recession. At the end of the day, true market access can only be restored when the island’s debt burden is finally aligned with its economic resources, something that hasn’t happened in a long time.

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