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Credit Research - 08 Aug 2011
Baa1 AND NEGATIVE OUTLOOK ASSIGNED TO TWO NEW SERIES OF DEBT
Puerto Rico (Commonwealth of) State PR
Moody's Rating ISSUE
Government Facilities Revenue Bonds, Series R (Qualified School Construction Bonds--Federally Taxable--Issuer Subsidy Baa1 Sale Amount $756,000,000 Expected Sale Date 08/09/11 Rating Description General Obligation Government Facilities Revenue Bonds, Series S Baa1 $300,000,000 08/09/11 General Obligation
Sale Amount Expected Sale Date Rating Description Opinion
NEW YORK, Aug 8, 2011 -- Moody's Investors Service has downgraded the general obligation rating of the Commonwealth of Puerto Rico to Baa1 from A3. The outlook is negative. Moody's has also assigned the Baa1 rating and negative outlook to two upcoming series of bonds. The Puerto Rico Public Building Authority Government Facilities Revenue Bonds, Series R (Qualified School Construction Bonds) are expected to be sold in the amount of up to $756 million. The Puerto Rico Public Building Authority Government Facilities Revenue Refunding Bonds, Series S are expected to be sold in the amount of $308.53 million. Both are expected to price the week of August 8. The downgrade also applies to those ratings that are based on or capped at the G.O. rating of the commonwealth (see list later in the report). SUMMARY RATING RATIONALE The downgrade to Baa1 and the assignment of a negative outlook reflect the commonwealth's continued financial deterioration of the severely underfunded retirement systems, continued weak economic trend, and weak finances, with a historical trend of funding budget gaps with borrowing. Needed retirement system reforms, in our view, may exacerbate strains on the commonwealth's economy and budgetary finances in the coming years. In addition, the rating reflects the following strengths and challenges: STRENGTHS * Strong management dedication to tax and fiscal reform, including reducing the budget deficit * Politically and economically linked to the U.S., with benefit of the nation's strong financial, legal, and regulatory systems * Large economy, with gross product exceeding those of 10 states and population exceeding those of 24 states * Broad legal powers to raise revenues, adjust spending programs, and employ borrowing in order to maintain fiscal solvency CHALLENGES * Very low pension funded ratios relative to U.S. states * Very high government debt level relative to the economy, due in part to financing budget deficits. * High unemployment, low workforce participation, and high poverty levels compared to the U.S.; average income levels remain below 50% relative to the U.S. mainland median * Large size of commonwealth government relative to the economy (although recent government actions are reducing the size of the government employment sector) * Multi-year trend of large General Fund operating deficits, financed by deficit borrowing * Local economy that has been in recession since 2006 DETAILED CREDIT DISCUSSION STATUS OF THE RETIREMENT SYSTEM
The Commonwealth's pension plans are far weaker financially when compared to the pension plans of the 50 U.S. States, with a combined total funded ratio of just over 13%. The combined unfunded liability ($25 billion) and total net tax-supported debt ($42 billion) together represent roughly 7 times the annual budget, a combined burden that will exert significant budgetary pressure for many years to come. Based on the newly enacted reform plans for the retirement system, the commonwealth will be required to increase contributions into the plan, further straining the budget. While the majority of the unfunded pension liability is tied to a closed plan and therefore has a limit to its potential size, the magnitude of the unfunded liability still raises questions about affordability and sustainability. As of June 30, 2010, the date of the latest actuarial valuations of the retirement systems, the unfunded actuarial accrued liability (including basic and system administered benefits) for the Employees Retirement System (ERS), the Teachers Retirement System and the Judiciary Retirement System was $17.82 billion, $7.1 billion and $300 million, respectively, and the funded ratios were 8.5%, 23.3% and 16.3%, respectively. The ERS valuation stated that the ERS was likely to completely run out of money by 2019. The commonwealth's total combined funded status is 13.3%. Benefits and contributions to the ERS are determined by law rather than by actuarial requirements. The ERS defined benefit plans were closed in 2000. Since then, all new employees have been on a defined contribution plan, making the current difficulties finite in nature. The central government is responsible for approximately 64% of total employer contributions to ERS; the other 36% is the responsibility of public corporations and municipalities. Required employer contributions are 9.275% of payroll, while employee contributions vary according to salary and how benefits are coordinated with social security benefits. The actuarial valuation assumes an investment return of 7.5% per year and salary increases of 3% per year. The actuarially required contribution (ARC) for the ERS is $1.5 billion, or 16% of the commonwealth's General Fund budget. The 2010 employer contribution was $542 million, while the employee contribution was $303 million. Pension and benefit payments in 2010, on the other hand, were $1.5 billion. REFORM PLANS The commonwealth has announced a plan to increase employer contributions into the pension system. Currently employers contribute 9.275% of payroll to the pension system. The proposal increases the contribution by 1% per year for the first five years (starting in 2012), and then by 1.25% per year for the next five years. Under this proposal, the employer contribution rate will increase from 9.275% to 20.5% by 2021. The reform plan also calls for modifying the retirement system's loan program. Right now, ERS members can take out loans of up to $15,000. This maximum amount will be reduced to $5,000. This will increase liquid net assets of the system. The reform plan also calls for the retirement system to use $162 million (money which is being transferred from another fund) to buy a capital appreciation bond (CAB) issued by the Puerto Rico Sales Tax Financing Corporation (COFINA by its Spanish acronym), with a coupon of 7%, which will generate over $1.5 billion by 2044 (but not until then). The COFINA CAB will be subordinate to their existing subordinate bonds. It is estimated that these reforms will extend the liquidity of the ERS, so that the system does not run out of money until 2025 (versus 2019 if they do nothing). We also estimate that the increased employer contribution will cost the commonwealth approximately $300 million in additional contributions by the year 2021. The additional employer contributions, however, do not go far in making progress toward paying the actuarially required contributions (ARC). While the commonwealth contributed approximately 40% of the ARC in 2010, it is estimated that the increased employer contributions would bring contributions up to 45% of the ARC by 2021. MORE REFORM NEEDED, BUT WILL BE DIFFICULT TO ACHIEVE As the reform plan implemented by the commonwealth only extends the liquidity of the ERS by a few years, more reform is clearly needed. The commonwealth has in the past two years taken many significant actions to improve the finances of the island, and we therefore expect that it will continue to take actions to shore up its retirement system. Additional reform, however, will likely be politically challenging to pass, and could weaken the already weak commonwealth economy. REFORM ALSO BENEFITS TRS The Teachers Retirement Plan (TRS) had a funded ratio of 23.3% as of June 30, 2010. The commonwealth is the main contributor to the system, and the employer contribution rate stands currently at 8.5% of payroll. As with the ERS, assets have been declining, because the contributions have not come close to the actuarially required contribution (ARC), and the funded ratio has been declining. Unlike the ERS, the TRS is a defined benefit plan. As such, while the unfunded liability for TRS is much smaller than that of the ERS, the problem is not finite like it is for ERS. The plan to increase employer contributions will apply to TRS as well as ERS, which will provide additional liquidity to the system. It is expected that if the employer contribution rate rises along with that of the ERS, the increased cost to the commonwealth would be approximately $200 million by 2020. FINANCES, ECONOMY STILL VERY WEAK While the financial situation of the commonwealth is showing some improvement, it is still weak. The unreserved, undesignated fund balance was negative 25% of revenues in 2009 and negative 22% of revenues in 2010. The structural deficit has been reduced in the last two years: The commonwealth has achieved this through strict spending control (reducing spending largely through large government layoffs) and conservative revenue forecasting. The commonwealth has reduced employment by total 20,000 people (13,000 layoffs), or 8%. Total payroll expenses have been reduced by $907 million, or 16%, since 2009. The budget for fiscal year 2012 is $9.26 billion, up 1.2% from the fiscal 2011 budget. But it is down 15% compared to the fiscal 2009 budget. The spending increase in the 2012 budget includes a $186 million subsidy to PRASA to avoid a rate hike, and a 6% decline in debt service, due to assumed restructurings in fiscal 2012. Until the mid-2000s, Puerto Rico's economic growth direction tended to mirror that of the U.S. In 2006, however, Puerto Rico entered recession when the rest of the U.S. was still in full expansion mode. Since then, the commonwealth has remained in recession. Some economic variables are now trending up for the first time since 2006, but they are improving off a very low base, and reflect what is still essentially a weak economy, that is not likely to be able to absorb any additional stress. But the weak retirement system funding will challenge the commonwealth's finances and economy, as any new money put into the system will
essentially have to come from the government (weakening finances) or employees (weakening the economy). As the economy and financial situation are both now showing improvement but are still very fragile, this additional challenge will likely be difficult for the commonwealth to manage. ACTION AFFECTS MULTIPLE CREDITS The downgrade and negative outlook affects general obligation bonds of the commonwealth, and also affects bonds whose ratings are determined by or linked to that of the commonwealth. Impacted credits are listed below. DOWNGRADED TO Baa1 FROM A3 --General obligation bonds --Pension funding bonds --Puerto Rico Infrastructure Finance Authority (PRIFA) Special Tax Revenue Bonds --Convention Center District Authority Hotel Occupancy Tax Revenue Bonds --Government Development Bank (GDB) Senior Notes --Municipal Finance Authority (MFA) Bonds --Puerto Rico Highway and Transportation Authority (PRHTA) Transportation Revenue Bonds DOWNGRADED TO A3 FROM A2 --Puerto Rico Highway and Transportation Authority (PRHTA) Highway Revenue Bonds DOWNGRADED TO Baa2 FROM Baa1 --Bonds backed by General Fund appropriations --Puerto Rico Aqueduct and Sewer Authority (PRASA) Revenue Bonds --Puerto Rico Industrial Development Corp. (PRIDCO) Revenue Bonds
The rating outlook for the Commonwealth of Puerto Rico is negative, reflecting the stress the commonwealth will face in the next few years as it continues to attempt to address the underfunding of the retirement system from an already weak financial and economic position. What could move the rating--UP --Significant improvement in the condition of the commonwealth's pension system. --Strong rebound in economic growth leading to improved and sustained revenue results. --Spending controls that lead to long-term improved budgetary results and outlook. --Reversal of General Fund's deficit position. What could move the rating--DOWN --Continued deterioration in the pension plans' funded ratio. --Growth in structural budget gap and an increase in GAAP deficits beyond that which is expected in the near term. --Prolonged recession, resulting in declining revenues and deficit financing in excess of currently projected amounts. --Lack of market access. --Material increase in debt. The principal methodology used in this rating was Moody's State Rating Methodology published in November 2004. Please see the Credit Policy page on www.moodys.com for a copy of this methodology. REGULATORY DISCLOSURES For ratings issued on a program, series or category/class of debt, this announcement provides relevant regulatory disclosures in relation to each rating of a subsequently issued bond or note of the same series or category/class of debt or pursuant to a program for which the ratings are derived exclusively from existing ratings in accordance with Moody's rating practices. For ratings issued on a support provider, this announcement provides relevant regulatory disclosures in relation to the rating action on the support provider and in relation to each particular rating action for securities that derive their credit ratings from the support provider's credit rating. For provisional ratings, this announcement provides relevant regulatory disclosures in relation to the provisional rating assigned, and in relation to a definitive rating that may be assigned subsequent to the final issuance of the debt, in each case where the transaction structure and terms have not changed prior to the assignment of the definitive rating in a manner that would have affected the rating. For further information please see the ratings tab on the issuer/entity page for the respective issuer on www.moodys.com. Information sources used to prepare the rating are the following: parties involved in the ratings and public information.
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Emily Raimes Analyst Public Finance Group Moody's Investors Service Baye B. Larsen Backup Analyst Public Finance Group Moody's Investors Service
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