Tuesday, July 25, 2017

GDB: A Chronicle of an Insolvency Foretold

By on July 13, 2016

BY PHILIPE SCHOENE ROURA & LUIS J. VALENTÍN

When Government Development Bank (GDB) President & Chairwoman Melba Acosta resigned from her post last week, more than sending shock waves throughout the financial markets, her decision punctuated a defining moment that is emblematic of the institution’s unraveling.

Although months have passed since this newspaper first reported about the bank’s insolvency, which led to emergency legislation that kept the institution from being placed in syndication, the GDB’s demise has been a work in progress years in the making. The government’s fiscal agent jumped off the rails more than 10 years ago—when short-term debt was ratcheted up to fund public corporations and the central government’s unbalanced budgets, a practice known as deficit financing. The bank veered from its role as the lender for infrastructure works and as the fiscal agent responsible for economic policy to become a bankrupt lender of last resort.

The numbers are ominous indicators of the GDB’s inevitable insolvency. “Liquidity dropped from $5 billion in 1989 to less than $500 million in 2016, while at the same time the portfolio of loans jumped from $1 billion to $8.3 billion,” Acosta told Caribbean Business during an exit interview last week. “The loan-to-total-assets [ratio], which in 1987 was 16.4 %, is now 87%. And this is big—loan to deposits in 1989 was 21% and now is 188%.”

Ahead is a chronicle of the GDB’s unraveling, which is deeply rooted in the Puerto Rico government’s maladapted tendency to go to the U.S. municipal bond market to finance its deficit spending.

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Manos a la Obra

When Puerto Rico began to develop a vision of its public finances with the founding of the GDB in 1942, the government capitalized on the constitutional protection of its general-obligation (GO) debt.

“Because of our political relationship with the U.S., we had access to the municipal bond market, which is a privilege granted only to jurisdictions in the U.S. It is a privilege because the federal government grants the buyer of bonds exemption on the interest earned; the alternative is to sell your bonds in financial markets that are taxable, not tax exempt, and that was much more costly,” explained Alfredo Salazar, who headed the GDB on two occasions—in 1975 and again in 2005.

“We had access to the most attractive financial market in the world, raising capital at tax-exempt rates and long maturities. The fathers of our constitution, I believe, understood that to make certain that Puerto Rico continued to have access to this market and bring to the island the necessary capital to develop our infrastructure they gave the GOs, backed by the full faith and credit of the government, a constitutional protection as to the repayment of the bonds. It was a very powerful statement on their part,” he said.

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The best thing since sliced bread. Above is an ad for Puerto Rico’s sterling tax-exempt bonds that ran in Barron’s in 1975.

The market took the constitutional priority as a statement of credibility and commitment that Puerto Rico would honor its debts—with priorities. Puerto Rico’s access to the municipal market allowed the government to structure its public finances in a fashion that could maximize its capacity to sell bonds and bring capital to the island.

“You have an investment manager in a municipal bond fund that has money coming into the fund every day. He opens the screen and decides where to invest. He has a risk appetite—so, he buys some AAA, A, some BBB. He also has an idea of the yield he is looking for. Puerto Rico happens to be in the market selling [P.R. Electric Power Authority] Prepa bonds—‘I have some space for power bonds, let me buy $25 million in Prepa.’ Puerto Rico has GOs, water bonds, gas tax-, sales tax- and even rum sales tax-backed bonds. That is why Puerto Rico has 18 different entities issuing debt—and now some criticize that,” Salazar said. “But that was the strategy—to offer a diversity of bonds to the market to satisfy the appetite for risk of the different buyers of municipal bonds. It was done on purpose. It was tailor made for the municipal bond market.”

Unlike sovereigns such as Argentina, Puerto Rico has had the flexibility to issue some 18 different credits—the island structured its debt in a way that it could maximize access. With the debt issued by the commonwealth and the GDB’s guidance, Puerto Rico was able to finance important public works.

In those first decades of infrastructure development under Manos a la Obra, or Operation Bootstrap, Puerto Rico’s government had short-term lines of credit mostly for construction from large banks in New York that were paid when the investment generated revenues and long-term bonds were sold. “Once the revenues were generated and the coverage ratio was met, which meant that the public corporation was able to pay its debt, the GDB would make arrangements to sell the long-term bonds and pay off the line of credit,” Salazar explained. “And then we would start all over again.”

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Back to the future

Puerto Rico’s rollover machine came to a screeching halt in 1975 when New York City’s economy went belly up. The GDB’s inability to bond out its short-term debt called for recruiting Guillermo Rodríguez Benítez, who had been the second president of the bank in the 1940s, as Operation Bootstrap was getting underway.

When he took on the role, he asked for an understudy. Gov. Rafael Hernández Colón, in his first term as governor, gave him a rising young star in Salazar, who was yanked from under the wing of Fomento founder Teodoro Moscoso and whisked to the GDB in January 1975.

In a letter sent June 16, 1975, to Hernández Colón, Rodríguez Benítez warned about the dicey situation Puerto Rico got itself into by overusing the U.S. municipal bond market. The commonwealth’s credit was quickly deteriorating, interest payments were increasing “in an alarming way,” and bond prices began to go down. Despite the multiple issuers, all were seen as “Puerto Rico bonds,” thus they were affected equally in the market.

The frequency and volume with which the island tapped the market, along with budget deficits and a slowing economy, were the main drivers of the grim fiscal picture during the 1970s, according to Rodríguez Benítez. He recommended “firm and painful” corrective actions until Puerto Rico’s economy picked up steam once again and debt levels were stabilized.

FP graphHe urged not to create more public corporations with the intent of issuing debt, as well as not to undertake new projects, regardless of their importance, if they called for tapping into the muni market.

“Any public policy not directed toward bringing under control the fragile position in which we find ourselves, would put in danger the financing of the commonwealth’s programs. In fact, it could be already late,” said the 1975 letter, a presage of current times.

Both bankers, Rodríguez Benítez and Salazar, drew up a strategy to tackle the steep challenges the GDB was facing at the time. Together they struck a note purchase agreement with the banks. They took all the short-term notes issued by the commonwealth and put them into a deal that everyone participated in, which bought time until the market recovered.

The GDB, as the fiscal agent, mapped out the entire financial structure; Puerto Rico went to the European markets—London in particular, which was buoyed by petrodollars from the oil-producing nations. The GDB’s top brass went to that market for two relatively small transactions to finance public works. The GDB issued two Euro-bonds, which were short-term notes at seven years with interest that was taxable.

In his letter, Rodríguez Benítez said the prospects of using these markets were not encouraging, but without access to the muni market, the bank did not have many choices.

A tanking economy proved to be a formidable foe for Hernández Colón, who lost the elections in 1976 to Carlos Romero Barceló, who brought in Mariano Mier to run the GDB. Step by step, Puerto Rico re-entered the U.S. muni market as it opened up.

The beginning of the end

In 1996, the territory “USS Puerto Rico” dropped a depth charge that would blow its economy to smithereens—allowing Section 936 of the U.S. Internal Revenue Code to be targeted for phaseout by a Republican Congress headed by then-House Speaker Newt Gingrich. Former Gov. Pedro Rosselló, who was in his second term, said at the time that his defense of the tax credit had become untenable—the tax break granted U.S. manufacturing companies operating in Puerto Rico a 100% tax exemption on income kept in Puerto Rico banks.

More than 40% of Section 936 funds were held in local banks, including the GDB, which heavily relied on these monies as a low-cost funding source for the institution.

The depth charge continued to drop and deep down everyone knew it would blow. The GDB with Marcos Rodríguez Emma at the helm continued its “business as usual” bond issues. All told, some $12 billion in debt was issued to finance infrastructure works—the Tren Urbano, P.R. Coliseum, PR-66 and P.R. Convention Center—works that were commenced under the Rosselló administration.

The infrastructure works kept Puerto Rico’s economy growing at a 3% annual rate and no one was the worse for wear. However, the tectonic shifts occurring beneath the surface would eventually unleash a massive tsunami of outmigration and job loss over a decade that commenced in 2006, precisely the year that the phaseout of Section 936 was complete.

The first wave of job loss was masked by a public sector payroll that ballooned to 325,000 jobs under the administration of Sila María Calderón. Debt issued under her four-year administration was nearly $10.3 billion—close to the same amount that was issued under the eight-year Rosselló administration ($12.8 billion).

Although observers focus on Puerto Rico’s mammoth public debt, the trouble looming large on the GDB’s horizon traced to debt that was being issued to fund the central government and public corporations. Worse still, no sufficient revenue streams were pledged to repay for it.

“The bank went from providing interim financing to long-term loans that would remain in the portfolio. They were not bonded out,” Acosta said.

As the GDB’s deposits took a hit with the exit of Section 936 funds, the bank switched to commercial paper, or short-term debt financing, much as U.S. banks did in the 1970s. From the mid-1990s to 2009, the government bank had leveraged more than $1.5 billion in commercial paper, piggybacking on a strong GDB credit rating.

Although debt was still massive under the administration of Gov. Aníbal Acevedo Vilá ($15.95 billion), the GDB’s commercial paper program, dependent on having a sterling credit, provided a key funding source for the bank. While the municipal market was accessible, the GDB had the capacity to pay off this short-term debt. As one analyst who chose anonymity explained: “The GDB is a very simple entity—it has its demand deposits and its time deposits and notes that it sells in the market. And with that source of funding, they invest in U.S. Treasury bills, which are rather safe investment accounts.”

fp melba tableWhen the bank under Salazar, who returned in 2005, approved the sale of notes, the GDB sold more than $1 billion in a staggered maturity ladder. These notes had maturities of five, seven and 10 years. If investors paid a 3% coupon on these, the GDB would make certain that they invested in ironclad instruments such as U.S. Treasury notes that would pay at least 3.5%. The government would make half a point. They put the money in Ginnie Maes and other federal investment vehicles that provide a spread, and managed to build an investment fund that stood at nearly $2 billion at the end of the Acevedo Vilá administration.

But as the island’s economy started to show signs it was faulting, and credit-rating agencies began downgrading Puerto Rico’s credit, the commercial paper program was exposed.

By the time former Gov. Luis Fortuño took office in 2009, the program had ceased to exist. And a paradigm shift that occurred under the Acevedo Vilá administration—a joint resolution that authorized the GDB to lend to public corporations to relieve liquidity pressure from the general fund with an understanding that the loans would be repaid—was left unattended as though it had never existed.

“They requested legislation that authorized entities to borrow from the GDB and then in the process, authorized the head of the OMB [Office of Management & Budget] to declare that in future GO bond issues, revenues would be reserved annually to repay the bank,” said one source in the Legislature with knowledge of the measure. “When they left office, the Acevedo Vilá administration had a whole list of bond issues to be set aside to repay the GDB for the loans it had made. The loans had sources of repayment. But they never included that in the budget, never.”

The bank, slowly but surely, became a financier for the government’s general fund. “To fill the gaping hole left by the departure of Section 936 funds, the bank had to develop multiple financing vehicles,” explained Acosta to Caribbean Business. “In essence, the bank sought ways to free the general fund from the liquidity pressure it couldn’t sustain.”

During the Fortuño administration, which borrowed some $16.55 billion, the GDB was already being exclusively used for deficit financing, as the commonwealth continued to seek ways to access the muni market. The GDB notes, which substituted the 936-backed deposits and the commercial paper program, provided more than $4 billion in new credit facilities for the central government and its instrumentalities, which had no revenue to pay off these credit lines.

More than $9 billion were issued by the GDB in gross debt during the Fortuño administration, structured as short-term bullet maturities under the premise that the bank would be able to repay these as they came due.

Access to capital markets began to close not only for the GDB, but also the Puerto Rico government and its instrumentalities—a roller-coaster ride that is a story of its own.

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Is there a future?

“The GDB certainly has a future—if you believe in it. Unfortunately, some people don’t necessarily believe in it. But the GDB could have a future,” said Acosta of the ongoing debate of whether the institution should continue to exist.

However, there are many people who see this differently. Several lawmakers and mayors have publicly expressed their reservations about keeping the GDB and recommended moving toward other directions. For instance, Popular Democratic Party gubernatorial candidate David Bernier has already called for placing the bank on receivership because the institution is no longer viable.

The moratorium legislation enacted this year provided alternatives to the bank’s liquidation or receivership process, which was the only option available before the enactment of the local moratorium law. Ever since the enactment of this law, the bank has been on life support, operating under cash-outflow restrictions aimed at stabilizing its finances.  

Yet, Acosta highlighted municipal financing as one of the most important roles that the institution could have moving forward. “Municipalities have the CAE, which is the [municipal] property tax charge through CRIM [Municipal Revenue Collections Center]. That is a very good refinancing source. It is a good credit,” she said, adding that private banks are not facilitating this funding to municipalities.

“But it is a public policy decision of the government. What will the role of the bank be?” Acosta noted. “There must be a vision.”

As the island enters yet-another defining moment with the enactment of the Puerto Rico Oversight, Management & Economic Stability Act, or Promesa, perhaps the federal legislation’s fiscal control board would have a say on the matter. After all, it is empowered to recommend to the island’s next governor what he or she should do when it comes to the 64-year-old bank’s future.  

 

GDB’s Final Act

BY LUIS J. VALENTÍN

 

Although Puerto Rico’s economy had shown signs of stress by 2006, the exit of Section 936 funds that year and a need for cash prompted the local government to be even more creative in seeking access to external financing.

Government-Development-Bank-GDB featuredAs fiscal agent, the Government Development Bank (GDB) called the shots, helping the central government and its instrumentalities tap into municipal bond markets. It played a key role in the creation of new financing vehicles, such as once-blue-chip tax-backed bonds issued by the Sales Tax Financing Corp. (Cofina by its Spanish acronym)—a subsidiary of the GDB.

But the withdrawal of Section 936 deposits led the bank down a dodgy road in search of another funding source that could keep the money flowing to the government. After working for some years with commercial paper, the GDB started the short-term notes program in 2006, with Alfredo Salazar at the bank’s helm under then-Gov. Aníbal Acevedo Vilá.

The short-term notes program marked the bank’s doomed transformation, from strategic lender to main lead vehicle, along with Cofina, with which public deficits were financed amid an already-failing economy.

The idea was to use proceeds to refinance previously issued notes and fund the commonwealth and public corporations. The GDB issued roughly $11 billion in these instruments, mostly during the Luis Fortuño administration, and about half remained outstanding by 2013.

The short-term notes were marketed not only in the U.S., but also in Colombia, Peru, the United Kingdom, Chile, France, Germany, Hong Kong, Norway, Singapore, Sweden and Kazakhstan.

Nowadays, GDB paper is spread among hedge funds, local credit unions and individual holders. About half of the bank’s roughly $4 billion in outstanding debt is held locally, GDB President & Chairwoman Melba Acosta told Caribbean Business.

Was the plan to have most of the GDB debt in Puerto Rico? “Apparently,” she replied, noting how some of this debt is taxable and not necessarily the best credit, thus it was sold locally. But a chunk of these notes were given the commonwealth’s full faith and credit protection, virtually converting them into general obligations (GOs).

Meanwhile, a large amount of GDB borrowers stopped paying their loans. Appropriations from the general fund were never sufficient and future bond proceeds failed to materialize as planned with no market access—both of which were believed to be the repayment source for these loans. The bank’s outstanding balance of credit facilities more than tripled during the 10-year period.

Of the $3.5 billion GO issue in 2014—mostly sold to nontraditional investors—about $2 billion went to the bank. In a nutshell, the Alejandro García Padilla administration bonded out debt owed by the government to the GDB, converting $2 billion in constitutionally protected GO bonds. But it was not enough and the government sought other options.

“That was what we wanted to do with la crudita—bond out the $2 billion [outstanding loan given to] the Highways & Transportation Authority to give liquidity to the GDB,” said Acosta, in reference to the administration’s failed attempt to issue as much as $3 billion in debt backed by the most recent hike to the petroleum products tax.

With no access to markets and no money entering its coffers, the bank faced principal payments hitting at once. More than $1.7 billion in principal has been paid by the GDB during the past five years, reducing its debt load to $3.8 billion.

Lacking a refinancing facility, the bank began using its resources to meet these payments. For instance, management has been selling assets, such as performing loan portfolios, to prop up its cash position.

While the math is simple, it was only a matter of time before the GDB became insolvent and receivership demands began.

Throughout the first months of the year, various GDB depositors, including the central government, began to place their deposits in commercial banks. In April, Gov. García Padilla placed the GDB on life support by changing its charter law to provide options to receivership and enacting restrictions on its cash outflows. A month later, the bank finally defaulted on $367 million of principal due May 1.

 

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