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Credit FAQ

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What Are The Credit Implications Of Puerto Rico's Debt Reduction Measures?
Primary Credit Analyst: David G Hitchcock, New York (1) 212-438-2022; david.hitchcock@standardandpoors.com Secondary Contact: Horacio G Aldrete-Sanchez, Dallas (1) 214-871-1426; horacio.aldrete@standardandpoors.com

Table Of Contents
Frequently Asked Questions Related Criteria And Research

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Credit FAQ:

What Are The Credit Implications Of Puerto Rico's Debt Reduction Measures?
Standard & Poor's Ratings Services has affirmed its 'BBB-' rating with a negative outlook on the Commonwealth of Puerto Rico's general obligation (GO) bonds and appropriation-backed debt. The rating on Puerto Rico has been the subject of increased discussion in the media and among market participants. This report covers frequently asked questions Standard & Poor's has received recently about its rating on the commonwealth.

Frequently Asked Questions
Why is the rating on Puerto Rico still investment-grade?
Our investment-grade rating on Puerto Rico reflects our view of the commonwealth's recent efforts to rein in its structural deficit, which has been funded for more than a decade by deficit financing and one-time budget measures. There has also been action to reform Puerto Rico's pension system, which has extremely limited asset accumulation relative to liabilities. The current administration has enacted significant corporate tax increases, including reinstatement of 2010 corporate tax rates, an adjustment to the corporate alternative minimum tax, a gross receipts tax, and other measures to rein in a very large deficit that occurred in fiscal 2013. We calculate that, if budget targets are met, the Puerto Rico general fund would need to fund about 7.9% of its budget in fiscal 2014 with some form of deficit financing, a reduction from a 22% structural deficit of ongoing revenues minus ongoing expenditures that occurred in fiscal 2013 based on the most recent information we have received. Puerto Rico has budgeted for about a 28% increase in the sales and use tax base in fiscal 2014 as a result of the new tax law. Some of the new tax measures will take up to six months to implement before the commonwealth begins to receive collections at the higher level. Fiscal 2015 should see an automatic bump up in revenues to reflect a full year of collections on the expanded tax base, assuming economic assumptions hold. In addition, Puerto Rico made a significant reform to its pension system this year to avoid a large step-up in pension payments in 2020, even at the expense of a slightly larger budget gap this year. This reform will bring it closer to structural budget balance. Recent increases in rates imposed by Puerto Rico's Water and Sewer Authority (PRASA) are designed to eliminate the $70 million general fund subsidy provided in fiscal 2012. Through its actions, in our opinion, the commonwealth has indicated a willingness to address its structural issues. We think Puerto Rico has a large and diverse enough economy of 3.7 million people for its debt to be rated investment-grade, but recent economic trends have been a concern. One favorable development has been an increase in tourist visits, although tourism is a small part of the overall economy.

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Why do we have a negative outlook on Puerto Rico?
The outlook reflects our belief that, if current trends continue, there is a greater than 1-in-3 chance we could lower the rating on the commonwealth within our two-year outlook horizon, which began when we assigned the negative outlook in March 2013. These trends include more than a decade of deficit financing for operations, and recessionary economic conditions every year except one since 2006, which has contributed to worse-than-budgeted financial results.

What key factors could cause Standard & Poor's to either change the rating on Puerto Rico or move the outlook back to stable?
The key element we are monitoring is whether Puerto Rico's finances will perform as the current administration projects. The commonwealth projects a general fund deficit requiring approximately $820 million of external financing in fiscal 2014, or about 7.9% of expenditures on a budgetary basis, a small deficit in fiscal 2015, and balanced operations in fiscal 2016. If the deficits are significantly larger than that, we could possibly take a negative rating action. We could also act if we felt that economic deterioration was so severe it made structural budget balance effectively impossible to achieve by fiscal 2016, or if Puerto Rico's liquidity deteriorated so as to create operational problems.

When would we take a rating action, assuming budget projections have not been met?
We are continually monitoring Puerto Rico's financial and economic performance and could take action at any point within the two-year outlook horizon should certain conditions be met. We could potentially take a rating action if, in our view, the fiscal 2014 deficit is significantly higher than budgeted. We expect that there will be a clearer picture of current budget conditions when the governor introduces his budget proposal for fiscal 2015. However, if information before then indicates a significant deviation, we reserve the right to take a rating action. It is possible we could maintain the negative outlook even if fiscal 2014 were in line with the commonwealth's forecast. The outlook for structural balance in 2015 and 2016 will also factor into future credit direction. Coloring the fiscal outlook will be the general condition of the economy, whether the fiscal 2014 deficit was kept at $820 million, and if uncertainty remained over whether a significantly reduced deficit was possible in fiscal 2015 and balance in 2016.

Are we concerned about market access for Puerto Rico debt? Is it a credit concern?
We have noted the recent deterioration in pricing for Puerto Rican debt, including debt for various agencies and the Puerto Rico Government Development Bank (GDB). Market access is a concern, particularly since the commonwealth will need to finance at least $820 million of its deficit in fiscal 2014, and an additional deficit in fiscal 2015. Puerto Rico has recently privately placed GO bond anticipation notes (BANs), and also privately placed BANs of the highway authority. We currently anticipate that Puerto Rico will be able to refinance its highway authority debt based on a recent legislated increase in highway authority revenues. Puerto Rico has announced an intention to fund its general fund debt financing needs for fiscal 2014 through Puerto Rico Sales Tax Financing Corp. (COFINA). We believe Puerto Rico currently has market access, at a price, through its proposed third-lien COFINA debt, which we view as having legal separation from potential constitutional "clawback" provisions for GO debt. If Puerto Rico loses effective market access to the debt markets, it could become a credit concern, as it might become difficult to fund operations. Our assessment of Puerto Rico's cash flow projections indicate it has already privately placed sufficient cash flow notes to maintain general fund cash flow through fiscal 2014, absent significant deviation from budgeted

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projections, and that it could privately refinance BANs maturing within the next year, although at a potentially high price, without access to the public debt markets. However, we believe relying on private placements for a year would be potentially costly, and perhaps difficult. In our view, anticipated public financing through additional sales tax-secured COFINA debt is currently a viable option, and is not immediately required in the next few months. Puerto Rico has taken recent steps to restore creditworthiness for its government agencies, including raising highway authority revenues, raising water and sewer and electric authority rates, externally financing agency debt that had been held by the GDB, and privately placing cash flow notes. Higher revenues of the various highway, water and sewer, and electric authorities could also reduce the need for general fund subsidies. At the same time, the high and increasing level of debt could lead to market saturation for some traditional institutional investors. We have noticed, however, increasing interest by hedge funds and nontypical investors, which could provide additional access to the market, albeit at a higher price.

What are current economic trends, and are they a credit concern?
Puerto Rico real gross national product has contracted every year since fiscal 2006, except for a 0.1% increase in 2012. The Puerto Rico GDB economic activity index indicates that the fiscal 2013 economic contraction has been continuing so far into the first part of fiscal 2014. Some of the factors contributing to economic contraction have been the loss of federal tax breaks for offshore manufacturers in 2006, high energy costs due to the cost of imported oil, and the effect of the Great Recession in the U.S. We understand that the current administration is focused on promoting job creation and overall economic development and investment, but these efforts have not offset overall decline. One hopeful sign is a recent pick up in tourism, although tourism is only about 2% of GDP. A continuing economic slide would be a credit concern, and contributes to our negative outlook. Should recessionary conditions continue, budget targets may slip, and it may be politically difficult to make midyear adjustments. The current governor has indicated that workforce layoffs are not an option. The effect on the economy of recent water and sewer rate hikes, and the recent reversal of previous tax cuts and the expansion of the sales and use tax to business services will, in our view, have an uncertain effect on the economy, but we feel there is downside potential.

Does Puerto Rico have adequate cash flow for the coming fiscal year?
Puerto Rico has arranged about $1.2 billion of private cash flow notes and credit lines for fiscal 2014, a small portion of which has already been repaid. Cash flow projections provided by the commonwealth show what we believe is adequate ending monthly cash flow through the end of fiscal 2014 without any further note sales. Through September, cash receipts appear to be running slightly ahead of original projections. However, a significant future deviation from projected cash flow could be a credit concern in our opinion.

If Puerto Rico were downgraded to below investment-grade or lost market access, are there contingent general fund liabilities that could create a credit cliff ?
Puerto Rico has $543 million of GO BANs that will need to be rolled over by Dec. 31, 2013, and $243 million of credit lines, with private participation, also due by Jan. 31. Failure to roll the BANs over by Dec. 31 does not trigger an immediate default, but triggers an interest rate step-up while the credit line does not have a step-up.

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Credit FAQ: What Are The Credit Implications Of Puerto Rico's Debt Reduction Measures?

As of Sept. 30, 2013, the commonwealth had $587.6 million of GO bonds outstanding that carried a variable interest rate, all of which were hedged with interest rate swap agreements. There is swap termination risk on $460.8 million of insured swaps if Puerto Rico's GO bonds are rated below 'BBB-' for 90 days and the insurer experiences certain downgrades (this has occurred on two swaps). A part of Puerto Rico's $1.86 billion notional amount of general fund supported swaps involves floating-to-floating-rate-basis swaps. If a one-notch downgrade were to occur, a swap collateral posting of approximately $75.9 million would be required. If a one-notch downgrade were to continue for 90 days, two of the insured swaps would terminate for a total of approximately $34.2 million (of the $75.9 million), which we believe could be covered by GDB current liquidity. Further swap terminations could occur if the GO debt is rated below 'Ba1' or 'BB+'. The interest rate swap agreement mark-to-market value of all general fund-supported debt as of Sept. 30, 2013, was negative $118.8 million. The variable rate interest rate risk on debt outstanding appears manageable to us in the very short term, since of the $587.6 million total variable amount, $203.6 million are variable-rate demand obligations, whose credit quality depends on the liquidity providers, and $257.2 million are floating-rate notes, whose interest rate is linked to an index. There is an additional $126.7 million of other GO variable-rate debt whose interest is linked to the CPI. Puerto Rico has reported to us that there were no current collateral postings under the general fund-supported variable-rate demand obligations (VRDO) swap agreements as of Sept. 30, 2013. However, somewhat longer term, we believe there is a rollover risk in the next nine months on the $203.6 million VRDOs when their current liquidity agreements expire June 21, 2014, for series 2003 C-5-2 GO bonds, and May 1, 2014, for series 2007 A-2 bonds. Either a renewal of agreements with existing liquidity providers will need to be negotiated, new liquidity providers will need to be found, or the bonds will have to be refunded into a different interest rate mode at that time. The liquidity agreements all have five-year, term-out agreements if the VRDOs become bankheld bonds. In addition, a liquidity agreement on $14.9 million of debt has an immediate termination if the insurer, Assured Guaranty Municipal Corp. (AA-/Stable), is rated below investment-grade or defaults on its policy. All of the liquidity agreements have step-ups in fees, bank bond held interest rates, and an optional demand tender after various notice periods, if we lower our GO rating on Puerto Rico to below 'BBB-', but a downgrade of the commonwealth does not trigger an immediate repayment to the liquidity providers. There is also rollover risk on the mandatory tender floating-rate bonds, whose tender expirations for the GO 2003 C-5-1 are on May 1, 2014 ($44,905,000), and on June 1, 2014, for the GO 2003 C6 ($197,385,000) and GO 2007 A3 ($14,925,000). The Puerto Rico Public Building Authority also has a fixed-rate mandatory tender bond with a July 1, 2017, mandatory tender date that will also need refinancing. Puerto Rico has announced plans to use COFINA, which we believe will allow market access, as a future bonding vehicle, which we believe could be a source of takeout funding. COFINA also has an additional $136 million of variable-rate debt, also hedged with an interest rate swap agreement. However, due to the higher rating on the sales tax-supported COFINA bonds, we view termination events for these bonds as less likely than for GO bonds. Puerto Rico Electric Power Authority (PREPA) and the Highways and Transportation Authority, which are separately

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secured from the general fund, also have variable-rate debt and swap agreements not included in this description of general fund contingency risk.

Can Puerto Rico declare bankruptcy?
It is our understanding that the U.S. bankruptcy code is silent on the ability of either states or commonwealths to declare bankruptcy, and this means that they cannot file for bankruptcy under the bankruptcy code. According to the commonwealth, local Puerto Rico municipalities are also not authorized to file for bankruptcy.

What is your view of the commonwealth's debt profile?
We believe debt levels are high and growing, and that the commonwealth will need to bring its external financing of budget deficits under control to maintain an investment-grade rating. We do not believe that the trajectory of the past is sustainable. We calculate total tax-backed debt at June 30, 2013, was $38.4 billion, including $15.2 billion of sales tax debt, $2.9 billion pension debt, and $5.6 billion of general fund guaranteed debt, and not including government agency debt of $25.2 billion. At this point, we believe that payment of debt service is achievable, but budget progress will need to be made. The fiscal 2014 budget reduces debt service by refinancing current debt service into later years' maturities. Currently, combined GO, PBA, and public finance corporation (general fund appropriation-secured) debt service due in fiscal 2014 is $1.16 billion (on total principal amount of $15.5 billion), before the debt service refinancing, or 11.9% of 2014's budgeted general fund revenues. Debt service from these three sources is currently scheduled to increase to $1.346 billion in fiscal 2016. In addition, the debt service currently due in fiscal 2014 for COFINA is $630.3 million, and is scheduled to increase to $681 million in fiscal 2006, on $15.2 billion principal amount of debt. This does not include the pension debt, or certain other tax-backed debt. The commonwealth has also indicated an intention to issue additional COFINA debt. There are also contingent debt risks, as described above.

Why does Standard & Poor's rate lease appropriation-backed bonds the same as GO debt?
In our view, Puerto Rico would lose needed market access by defaulting on either GO or appropriation-backed debt, a deterrent to paying certain debt and not other debt. Of the $38.4 billion of tax-backed debt we calculate above, appropriation-secured public finance corporation debt is $1.1 billion, or 2.9% of our calculation of the tax-backed total; we believe Puerto Rico would be reluctant to default on this portion of the debt and jeopardize its ability to access the market on the other liens. Existing statutes allow for a high prioritization for appropriations securing commonwealth debt, after payment of GO debt. Due to the broad band of credit quality within the 'BBB-' category, we do not believe the appropriation-backed debt merits placement in the speculative-grade category at this time, although its negative outlook mirrors that of the GO bonds. In particular, Puerto Rico statutes, Law 147 of June 18, 1980 -- Oficina de Gerencia y Presupuesto (Ley núm. 147 de 18 de junio de 1980, según enmendada) -- gives power to the management and the budget director to prioritize "binding obligations to safeguard the credit, reputation, and good name of the Commonwealth of Puerto Rico" second only to payment of public debt and equal to legal contracts in force and judgments of the courts; and above conservation of public health, protection of persons and property, public education programs, public welfare programs, and retirement system contributions, among other specific itemizations.

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Could PREPA or PRASA revenues get "clawed back" for payment of GO debt service under "clawback" provisions of the Puerto Rico constitution?
The Puerto Rico constitution prioritizes payment of GO debt service from first "available" revenues. This has been interpreted to mean certain available tax revenue could get "clawed back" for payment of GO debt service, but excludes certain internally generated revenue of public corporations such as revenues from the purchase and sale of services, such as electric and water and sewer services in the case of PREPA and PRASA, respectively, and tuition payments from students at the University of Puerto Rico. "Available" revenue also does not include sales tax revenue supporting COFINA debt service.

How does the Puerto Rico GO rating compare with the ratings on Caribbean island nations and other U.S. commonwealths?
Currently we assign sovereign credit or GO ratings to the territory of Guam (GO rating: BB-/Stable), Aruba (BBB+/Stable), Bahamas (BBB/Negative), Barbados (BB+/Negative), Bermuda (AA-/Negative), Jamaica (B-/Stable), and Trinidad and Tobago (A/Stable). We no longer have a GO rating on the U.S. Virgin Islands, a U.S. territory. While Puerto Rico's 2011 GDP per capita of $26,588 may be low by U.S. state standards, it is higher than that listed in our most recent rating reports for Aruba in 2011 ($23,295), the Bahamas ($22,250), Jamaica ($5,276), and Barbados ($15,596), for comparison. We believe other economic indicators appear favorable for Puerto Rico compared with some Caribbean island nations, in addition to the financial benefits of its U.S. commonwealth status.

Related Criteria And Research
• Puerto Rico full analysis, Oct. 24, 2013 • USPF Criteria: State Ratings Methodology, Jan. 3, 2011

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