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Credit Rating Agencies Ignored Signs of Deteriorating Gov’t Conditions

By on September 6, 2018

Editor’s note: The following originally appeared in the Sept. 6, 2018, issue of Caribbean Business.

While government mismanagement and a lack of willingness to right-size, among other reasons, may have contributed to Puerto Rico’s unsustainable debt, credit rating companies (CRA) such as Moody’s Corp., Standard & Poor’s (S&P) Financial Services and Fitch Ratings were also to blame, the investigation commissioned by the island’s fiscal oversight board found.

Requests for comment from some of the CRAs had not been answered as of press time. Rosemarie Vizcarrondo, chief of staff for the island’s Financial Oversight & Management Board said all questions will be answered Sept. 18 during a hearing on the report prepared by the independent investigator, Kobre & Kim, hired by the board.

The New York-based firm examined the fact that despite Puerto Rico’s worsening fiscal crisis and poor performance of certain issuers, the three CRAs rated the majority of Puerto Rico’s bonds as “investment-grade” until at least 2014, despite having evidence before that time of possible financial problems. The report also uncovered certain vulnerabilities with the CRAs that may have prevented them from sounding the alarm sooner.

“In light of the evidence we reviewed, reasonable minds can differ regarding the point at which the CRAs should have stopped relying on prospective information supplied by or on behalf of the Issuers, anticipated an increased likelihood of default, or taken more aggressive actions like downgrading Puerto Rico-related bonds below investment-grade status. Indeed, our investigation uncovered evidence that the CRAs had persistent concerns with respect to certain Issuers and their issuer-supplied information prior to the 2014 downgrades,” the report reads.

The CRAs and the ratings they assign serve an important function in the municipal bond market. They also provide outlooks as to why they could change a rating. The report says it did not find evidence to suggest that the CRAs departed from their general processes and procedures in rating Puerto Rico’s bonds but noted there were vulnerabilities in their processes and procedures.

“There is evidence that, in hindsight, there may have been a basis to take earlier or more aggressive action to change the positive ratings of certain Puerto Rico-Related Bond ratings. At least some of the CRA Analysts with whom we spoke identified longstanding concerns…. There is also evidence that certain CRA Analysts were skeptical of prospective issuer-supplied information,” the report states.

While evidence suggests CRAs may have been worried about the dependability of their risk evaluations, they did not begin to lower ratings until Puerto Rico’s Government Development Bank (GDB) showed unwillingness to continue to help finance certain government entities and it became clear the commonwealth would default as well as the enactment of the Puerto Rico Public Corporation Debt Enforcement & Recovery Act of 2014, the report says.

The CRAs got most of the information for their evaluations from the debt-issuers themselves or from an entity acting on the issuers’ behalf such as the GDB and then determined ratings following a committee vote. Moreover, they typically conveyed their assigned ratings to the issuers or the GDB via a draft rating opinion to permit the issuer to correct any factual errors and flag any confidentiality issues. The CRAs also allowed the issuers to appeal ratings determinations based upon “new” or “material” information the CRAs had not previously considered.

In general, the ratings, which were analyzed from 2006 and on, for most of the Puerto Rico-related bonds declined over time, but maintained investment-grade status until Moody’s and S&P dropped their ratings for the senior-lien series of Puerto Rico Aqueduct & Sewer Authority (Prasa) bonds to noninvestment-grade in December 2012 and March 2013, respectively.

All three CRAs subsequently dropped their ratings for the general-obligation (GO) bonds to noninvestment-grade in early February 2014. The CRAs generally rated Puerto Rico Sales Tax Financing Corp. (Cofina by its Spanish acronym) bonds higher than the other bond groups, GOs, Prasa, Puerto Rico Electric Power Authority (Prepa) and Employees Retirement System (ERS) as they relied on Cofina’s structure and separation of its revenue stream for the rating.

The debt probe, however, revealed two primary weaknesses in how the CRAs developed their rating action. First, the report says, issuers had the “power to frame the ratings analysis; and second, the ratings largely resulted from discretion and individual perception as to what weight, if any, to give certain information that, in the context of Puerto Rico-related bonds, should have had heightened significance,” such as “forward-looking projections, Puerto Rico’s vulnerability to and the economic impact of hurricanes, the actual use of bond proceeds, and the impact of a CRA’s own ratings downgrade.”

The investigator did not find evidence to establish that CRAs factored natural disasters into their analysis for most Puerto Rico-related bonds despite the island’s susceptibility to major hurricanes. The evidence similarly does not reflect that they required their analysts to “uniformly” consider an issuer’s use of bond proceeds to operate.

“Arguably, the use of bond proceeds to bridge operational deficits signals that the Issuer is in some degree of financial distress, or has a weak budgeting function,” the report says. For Prasa and Prepa bonds, the CRA analysts did not typically consider actual use of proceeds in making ratings determinations. The analysts who rated GO bonds said the intended use of proceeds would have been more important for evaluating that type of bond but, in reality, was not taken into account, according to the report.

“One CRA Analyst for Cofina further conveyed that whether proceeds were used to finance swap termination fees would not, in this analyst’s view, have been a material consideration for the Cofina Bonds. A different CRA Analyst who rated Cofina and ERS Bonds, however, confirmed that if the bond proceeds were intended to pay existing deficits, then that would have factored into the analyst’s analysis,” the report reads.

Furthermore, CRAs admitted they typically received “outdated and/or unaudited financial statements for Puerto Rico and related Issuers” as part of their analysis, but still went on to provide a rating.

“Despite the general lack of timely audited financials, we are not aware of any instance in which a CRA declined to rate, or took negative actions regarding, a Puerto Rico-Related Bond due to missing or stale financial data. In fact, the available evidence is inconclusive regarding how delayed or unaudited financials may have impacted the assigned ratings.

“This is because the CRA analysts with whom we spoke gave differing accounts of the potential implications of those materials. Like most other things, reliance upon outdated or unaudited financial information appears to have been a matter of discretion even where, as here, the financials were habitually late and certain Issuers demonstrated declining performance,” the report continues.

Still, the evidence suggests that before 2014, CRAs were already worried about credit-relevant conditions. Many of the CRAs’ adverse rating adjustments, watch assignments, and outlook revisions appear to have been based, at least in part, on conditions that had persisted for some time.

Mounting concern

For instance, S&P’s downgraded Prepa bonds to a lower investment-grade rating in June 2013 for factors S&P cited were not new, such as weakness of Puerto Rico’s economy, dependence on fuel oil, large capital requirements needed for conversions and limited liquidity.

CRA analysts said that by the time of the adjustments to noninvestment-grade, they had held concerns about certain island issuers. These include, among others, that ERS was too generous a system and lacked adequate funding from its inception; the fact that Puerto Rico’s economy had been lagging and never fully recovered from the financial downturn that began in 2006 and broken meters and substantial percentages of energy theft at Prepa.

“Notwithstanding these longstanding concerns, the CRAs elected to maintain investment-grade ratings for all Puerto Rico-Related Bonds other than the senior-lien Prasa Bonds until at least February 2014,” the report says.

Before 2014, the report says CRA analysts did not appear to be entirely comfortable with certain information they received from some Puerto Rico issuers. This includes prospective information about stated policy goals and projected performance.

“A CRA Analyst described to us how, at some point in 2013, the Analyst began to notice that the Public Utility’s projections were out of step with what the CRA would have expected, and the Public Utility’s financial information did not appear to be supported by its audited figures. Despite all of this, the CRA chose to maintain the Public Utility’s investment-grade ratings until February 2014,” the report reads in reference to Prepa.

“In a similar vein, another CRA Analyst described having doubts as early as 2010 regarding the same Public Utility’s ability to implement its capital improvement plans. The CRA Analyst eventually lost confidence at some point between 2012 and 2014. The CRA Analyst conveyed that the Analyst initially viewed the plan as credible based on the reports and other information that the Public Utility supplied, but that progress had not been made despite the passage of a year and a half from the program’s announcement. The CRA did not immediately lower the Public Utility’s Bonds to noninvestment-grade, but instead reduced them gradually over approximately 18 months,” the report states.

Until the Recovery Act, which enabled the commonwealth to overhaul the debts and labor contracts of public corporations, the CRA analysts assigned great weight to the issuers’ perceived ability to access financial support from the GDB.

“In their view, that statute brought a degree of clarity that, despite ongoing economic difficulties, was previously lacking regarding such matters as the Issuers’ lack of critical legislative support, the likelihood that Puerto Rico would not repay its bonds as anticipated, and the possibility that Cofina bondholders would not be prioritized as previously assured,” the report says.

At Fitch, for example, the Recovery Act triggered downgrades “when Puerto Rico ceased its willingness to issue appropriations to Prasa to cover revenue shortfalls. The downgrades of the GO Bonds and others in early 2014 were similarly linked to liquidity and market access concerns,” the report reads.

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