Reality bites, and so does Luis Suarez. Just when muni traders thought they could enjoy the tax-exempt market’s tremendous performance to date and just focus on World Cup drama, Puerto Rico is once again making the headlines.

Over the weekend, local media outlets started reporting that meetings were being held in the Senate to re-introduce a “local bankruptcy law,” with the intent of getting it passed by the end of the current legislative session on June 30th. Even as late as Tuesday night, Governor Padilla  reiterated his opposition to a bankruptcy of the public benefit corporations (PBCs), while confirming that discussions with key legislators on the very topic were in fact taking place. On Wednesday morning, faced with the inevitable, the Governor and his staff made an about-face and threw their support behind a proposed law to restructure PR’s pubic corporations. At this writing, the proposed law was reportedly passed by the PR House at midnight on Wednesday night.

The Recovery Act further provides two different paths to an eventual successful restructuring.

The catalyst was, of course, PREPA’s deteriorating liquidity position over the past few weeks: the utility has been running out of cash to even purchase fuel and has been trying to renegotiate its lines of credit with its banks. The potential failure of such negotiations would have forced the GDB to step in, which would have been a huge step backward in the ongoing efforts to make PREPA more self-reliant. Ironically, as soon as rumors of the new legislative proposal started circulating, negotiations with the banks reportedly came to a screeching halt.

According to the government’s press release, the proposed legislation, rather euphemistically called “The Public Corporations Debt Enforcement and Recovery Act,” is intended to “provide a clear legislative framework for certain public corporations that  are experiencing severe financial stress to  overcome their financial obstacles through an orderly, statutory process that allows them to handle their debts fairly and equitably, while ensuring the continuity of essential services to citizens and infrastructure upgrades.” In other words, it provides a quasi-bankruptcy process for distressed public corporations, whereas such a legal framework doesn’t currently exist under PR law. (We have posted the most recent English version of the proposed law here).

The Recovery Act further provides two different paths to an eventual successful restructuring. The first, called “Chapter 2” (although we’re not sure what “Chapter 1” is), calls for consensual negotiations between the corporation and its creditors. Should such negotiations fail to bear fruit, then the process will be turned over to a local court through what is called “Chapter 3.” At first blush, Chapter 2 appears to be inspired by California’s AB 506 process, although it’s not clear whether or not it would require appointment of a mediator, and Chapter 3 looks like the actual local bankruptcy process.

Several governmental entities are specifically excluded from the proposed legislation: the Commonwealth itself, the 78 municipalities of the Commonwealth, GDB and its subsidiaries, affiliates, and ascribed entities, the Children’s Trust, the Employees Retirement System, the Judiciary Requirement System, the Municipal Finance Agency, the Municipal Finance Corporation, the Puerto Rico Industrial Development Company, the Puerto Rico Industrial, Tourist, Educational, Medical and Environmental Control Facilities Financing Authority, the Puerto Rico Infrastructure Financing Authority, Puerto Rico Sales Tax Financing Corporation (i.e. COFINA), the Puerto Rico System of Annuities and Pensions for Teachers, and the University of Puerto Rico.

As best as we could tell, all the excluded entities share a common thread: they all have direct or indirect ties to the General Fund, and, in a workout scenario, would have dragged the Commonwealth’s G.O. credit down with them.

Not too surprisingly, the insurers will be on the front line of this latest development. Shares of Assured Guaranty (AGO) and MBIA Inc. (MBI) went down 3% and 4.5%, respectively, on Wednesday.

By carefully separating the G.O. bonds and closely-related credits from the PBC credits, the Administration and the legislature once again confirmed their support for the G.O. pledge, even though such pledge is already constitutionally protected.

Based on their disclosure as of March 31, 2014, Assured Guaranty has, by our calculations, about $2.72 billion in exposure to entities that have not been explicitly excluded from the “Recovery Act:” $1.17 billion in PR Highways, $852 million in PREPA, $384 million in PRASA, $185 million in PR Convention and $124 million in PR Public Building Authority. MBIA/National, for its part, reported about $2.5 billion in exposure to such entities, consisting of $1.53 billion in PREPA and $974 million in PR Highways. PREPA, PRASA and PR Highways are, of course, widely viewed as the top candidates for “restructuring.”

Admittedly, the Commonwealth has handled this delicate but long-overdue matter as well as it could have under the circumstances. By carefully separating the G.O. bonds and closely-related credits from the PBC credits, the Administration and the legislature once again confirmed their support for the G.O. pledge, even though such pledge is already constitutionally protected.

Judging from the market’s reaction so far, this message is coming across loud and clear. After hitting a new low price of 84 yesterday, the PR G.O. 8.00% of ’35 have rallied by as much as 5 points today. Conversely, the shorter maturity PBC bonds, such as the PRASA 5.00% of 2015, have sold off by as much as 20 points, simply because traders did not see a restructuring as anything imminent and were caught off-guard. The longer-term PREPA bonds only declined modestly as most of them are already trading at dollar prices in the 60s, a level that already incorporates some sort of restructuring scenario.

So the inevitable outcome that we, along with many others, have been predicting for a while is finally here. The public corporations which, for decades, have grown bloated and inefficient from over-reliance on the Commonwealth’s support, must now justify their existence as self-supporting entities. Over the next few days, many of us will be poring over the text of the proposed law to figure out the actual mechanics of this new “bankruptcy” process. Still others will start the daunting process of estimating the recovery value of the PBCs assets, in anticipation of lengthy, probably contentious, negotiations with the unions on the other side of the table.

Would the latest news out of PR create another wave of redemptions from the mutual funds? We doubt it, unless the overall interest rate environment turned negative again, in which case this will just give investors another reason to stampede out of bonds. It would be interesting though to see how the national media, always prone to sensationalism, will cover these latest developments.

Last but not least, we would be quite remiss if we didn’t end on this note: Go Team USA!

[Note: Serious investors with a significant interest in PR bonds may want to check out our new “Puerto Rico Investment Monitor” service, which offers more in-depth research and actionable investment ideas than can be covered in this public forum. For details, please contact us at ].

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