Huge Default Looming in Municipal Bonds

Oil and politics pave path leading toward $9 billion default for Puerto Rico Electric Power Authority.

The Puerto Rico Electric Power Authority wasn’t destined to fall $8.6 billion in debt, putting it on the cusp of the biggest default in U.S. municipal bond history. Reaching this point required a unique combination of bad decisions and poor execution. ‎A decades-long failure to wean itself from the use of expensive fuel oil has left the government-run utility with electric rates among the highest in the U.S. The result: On an island where about half the people live below the U.S. poverty line, the agency loses a sixth of its energy to theft and, at one point last year, was owed about $1.75 billion in unpaid customer bills.

While Prepa, as it’s known, has tried to escape its oil dependency, its efforts—including the failure of an experimental nuclear plant and two unsuccessful tries at building natural gas pipelines—have largely fallen flat, leaving the agency struggling to survive.

“Prepa has become a dinosaur,” said Pedro Nieves-Miranda, special counsel for Puerto Rican law firm Fiddler, Gonzalez & Rodriguez PSC and the former chairman of a task force that studied the authority in 2012. “If you can think of an inefficiency at a utility, you’ll find it there.”

Now, Prepa’s own bill is coming due.

Teetering on a default that would reverberate across the $3.6 trillion municipal-bond market, the authority is rushing to complete a restructuring deal before a US$416 million payment comes due July 1.

In April, bondholders offered a plan to inject $2 billion in private investment to help the utility modernize and repair its finances. In return, Prepa would give up ownership of one of its largest generating stations to private operators. The authority’s chief restructuring officer has criticized the proposal, saying it wouldn’t comply with environmental rules or offer any sacrifice by investors. Talks are continuing.

If it works, the plan could give the agency breathing space and help cut electric rates by as much as 20 percent. Failure could push Puerto Rico deeper into financial trouble, hampering its ability to borrow.

“This is not just about how we restructure one agency’s ‎debt,” said Carlos Rivera Velez, chairman of the 1,200-member‎ Puerto Rico Manufacturers Association. “This is about ensuring that economic development continues to be the cornerstone of Puerto Rico. Prepa is at the center of that.”

Yohari Molina, an authority spokeswoman, didn’t respond to messages seeking a comment. In April, Chief Restructuring Officer Lisa Donahue told the Puerto Rican Senate that the agency was making progress, including upgrades to billing systems and payment plans for overdue clients.

 

‘Far Behind’

“It was clear to me that Prepa was far behind the industry in virtually every respect,” said Donahue, who was hired in September as part of an agreement with creditors. Since then, “Prepa has made significant strides to improve its operations, but we have more work to do.”

Prepa’s just the most imminent challenge for the U.S.‎ territory, whose $72 billion in government and public agency bonds have traded at distressed levels for more than a year over fears they won’t be repaid.

“All of Puerto Rico is in the same mix,” said Richard‎ Donner, a New York-based analyst with Moody’s Investors Service. “The central government, municipal governments—all of them have borrowed a lot of money on an island that is still relatively poor and has had no growth for years.”‎

Puerto Rico’s woes have been likened to New York City’s financial crisis in the 1970s, but without the prospect of a rescue from Washington. Congress and the Obama administration have so far shown no inclination to offer the kind of loans that helped New York keep access to credit markets.

In September, Moody’s downgraded Prepa’s already junk-rated bonds to a Caa3 rating, indicating a “very high credit risk.”

Prepa bonds maturing in July 2042 traded Monday at an average of about 53.31 cents on the dollar, to yield 10.2 percent, or almost seven percentage points above benchmark munis, according to data compiled by Bloomberg.

The tax-exempt notes are held across the municipal-bond market, by both hedge funds and traditional investors including Oppenheimer Inc. and Franklin Resources Inc. In the event of a default, the bonds would be worth about 65 percent to 80 percent of face value, Moody’s estimated in a March report.

To be sure, Prepa operates in difficult circumstances on an island lacking in domestic sources of fuel. High power costs are endemic to island jurisdictions—Hawaii, Guam, and the U.S. Virgin Islands have similar or more expensive rates, according to the U.S. Energy Information Administration. But where Hawaii has pushed aggressively into wind and solar and the Dominican Republic has shifted most of its generating fleet to natural gas, Puerto Rico’s been slow to cut its dependence on oil imports, Donner said.‎ ‎

With crude prices soaring above $100 a barrel in recent years, that’s translated into some of the highest electricity rates in the region: about 24 cents a kilowatt-hour as of December, according to Moody’s. That’s twice the average on the U.S. mainland.

Meanwhile, the latest drop in crude prices is probably “too little, too late” to help the agency in its present problems, Donner said, in part because the authority’s required to pass most of its fuel savings on to customers.

 

Lights Stay On

The fuel problems have been compounded by political‎ meddling and mismanagement, said Nieves-Miranda, the Puerto Rico attorney. While the electric supply is generally reliable, the agency’s fallen behind on everything from equipment renewal and managing inventory to its customer-service and billing systems, he said.‎

As of September, the authority was owed more than $1.75‎ billion in unpaid bills, including $760 million from government customers, researcher FTI Capital Advisors found in a report for creditors last year.

Local towns may not pay for their power, but the lights stay on—and on and on. It’s not uncommon to find municipal soccer stadiums on Puerto Rico empty but illuminated through the night, while mayors compete with one another for the most lavish lighting displays around Christmas time, all free of charge. The western city of Aguadilla, which has an average temperature of 78 degrees Fahrenheit (25.5 Celsius), runs an ice-skating rink.

The utility needs more independence from political leaders, Donahue, the restructuring officer, told the Puerto Rican Senate. The commonwealth has had a series of one-term governors since 2001, and each new administration has replaced about 200 of the authority’s top managers upon taking office, she testified.

In February, a group of customers sued the authority in U.S. District Court, alleging that Prepa managers took kickbacks in exchange for accepting non-compliant fuel oil from suppliers including Royal Dutch Shell Plc and Petroleo Brasileiro SA, Brazil’s state-owned oil company. Residents were overcharged more than $1 billion as a result, the suit alleged. Petrobras and Prepa didn’t respond to emails asking about the case. Shell declined to comment.

Businesses are speaking with their feet, according to Velez Rivera of the Manufacturers Association.

“Companies have left, and companies have decided not to come,” he said in an interview. “And many companies are evaluating what they can do to dramatically lower costs.”

That includes investments in private power plants and solar arrays to help escape Prepa’s grid. The trend is likely to exacerbate the utility’s problems, unless it can figure out how to dramatically cut prices, Velez Rivera said.

The specter of default may finally have pushed Puerto Rican leaders toward action.

 

Agency Lifelines

The $2 billion plan by bondholders to modernize the utility could be a lifeline, while Donahue has promised her own recommendations by June 1. The authority has also hired Texas-based Excelerate Energy LP to build a $255 million terminal off the island’s southern coast to import liquefied natural gas. The port is due to open in 2017.

Prepa does have some advantages, including a workforce that, if too large, is still respected for its technical skill, according to Nieves-Miranda. A new utility board created by the government last year should provide more independent oversight, he said.

“That’s the problem that brought Prepa to its knees,” he said. “They could do whatever they wanted. They could be inefficient. They could start and not finish projects. They could stagnate and it didn’t matter. It was unregulated for too long. It was never accountable.”

 

--With assistance from Mark Chediak in San Francisco, Bill Faries in Miami, Michelle Kaske in New York and Alex Lopez in Puerto Rico.

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