the puerto rico banking system until 2008 william lockwood benet
TRANSCRIPT
THE PUERTO RICO BANKING SYSTEM UNTIL 2008
EXECUTIVE SUMMARY
The Report presents and fully documents a series of materially important, consistent and escalating alerts that were well known and readily available to the Puerto Rico banking system and their Boards of Directors when they sharply increased their lending and exposure to real estate loans:
1. The productive, export side of the PR economy, the one bringing in earnings from outside PR, abruptly changed and had major future competitive challenges. The consequences of the elimination of US IRC S936 and fiscal responses to the 2001 recession were troubling and the fundamental changes to reposition PR’s private sector development (PSD) were not addressed. In direct contrast to such challenges, growth during overheating and bubble period came from speculative real estate investment (financed by bank credit) and from government expenditures and investment (financed by debt), which also fueled intra-island trade and services (rather than for export). The Report confirms a pattern of boom and bust changes in private housing investment, total employment and tax revenues that confirm the existence of an unsustainable bubble.
2. The elimination of Section 936 was not addressed by measures to reduce operational costs (despite private liquefied natural gas (LNG) and coal cogeneration investments in energy), a significantly big push in the innovation economy supported by academic research (despite increases in UPR research grants and new private equity supply) nor by specific programs aimed at bringing growth-stage companies to PR or expanding local savings and local corporate groups in export-oriented activity and investment.1
3. Starting in 1996, PR moved from a federally subsidized production-focused economy (US IRC S936) to a PR-subsidized consumption-driven economy (financed by excessive imprudent government expenditures, public capital investment and bank credit concession). As a percentage of total establishment employment, manufacturing establishment employment dropped. Since no other sectors are leaders in exporting products and services, this reduction increased the exposure of overall intra-island systemic risks to public finances, credit concession and federal transfers. It was during such profound structural risk that the PR banking system, driven by perverse competition pressure, chose to embark on a massive increase in real estate loans and an asset bubble.
4. Without attending export and innovation strategies, four overlapping drivers sought to compensate the manufacturing crisis but were the result of poor strategic decisions and regulatory weaknesses:
a. First, the government went on a public infrastructure boom staring in the 1990s b. Second, the end of public investment was followed by the end of industrial and commercial
investment in real estate c. Third, starting in FY02 the public sector increased government expenditures and capital
investment relying on GDB resources, debt issuance and new taxes despite the fact that the export-led private sector was shrinking.
d. The fourth and last segment was the housing real estate boom. Private housing investment peaked between FY02-06 in current prices, when public, industrial and commercial investment had already dropped. In real terms, private housing peaked in FY02.
5. Bank credit growth grew imprudently to a massive overexposure in real estate, exceeding economic and personal income growth, in a structurally impaired economy without PSD strategy and
1 GDB was the only institution that assumed responsibility over channeling local savings and external investment into early, emerging and growth stage productive investment and innovation but its 1993-1994 efforts were overshadowed by overexposure to bank equities and the emergence of local mutual funds overexposed to PR government debt. Report to Government Development Bank for Puerto Rico, Puerto Rican Capital Markets, Recommendation for Their Expansion, Arthur D. Little, Inc., May 6, 1994, Reference 45953. The ADL Report recommended quickly starting a series of government and private sector sponsored programs to promote the expansion of private sector capital markets participants. These programs were aimed to shift the business focus of local firms and support venture capital and selected industry sector initiatives. As core proposal, the Report recommended changes in laws and regulations to remove barriers and distortions to private sector investors (Puerto Rican residents and offshore investors) to participate freely in the Puerto Rican capital market.
2
weakened public financial management. Priority was granted to higher margin, high risk loans, despite sustained internal and external alerts of structural and financial system problems. During CY08 the PR banking system drastically increased its net charge-offs to $923M, an increase of $342M or 59% over CY07. As a result of its exposure to real estate and halt in net credit concession to the economy, the PR banking system became another drag on the economy. By year-end 2008, $8.2BN of loans were in past-due and non-accrual status compared to $5.7BN in year-end 2007, up 44%.
6. Public sector deficits and debt also grew recklessly, limiting the role of the state to bring about innovation into productive sector, export activities and clearly in favor of real estate investment and bank loan credit quality. Central government expenditures including capital outlays and debt service increased from $10.3BN in FY01 to $15.3BN in FY01 and reached $18.3BN in FY08 as per CAFR All Governmental Funds.
7. By the time PR banks had to respond to the 2006 thru 2008 inverted yield curve they were in an extremely weak position and took highly speculative decisions to increase income in a perverse competition environment.
8. Rating agencies alerted repeatedly that worsening PR public sector financial challenges, combined with war on deposits, new taxes on banks, the US inverted yield curve and loan growth and pricing competition led to a reduced ability to manage an increasingly difficult operating environment for banks.
9. The value reduction of PR bank stocks is estimated at over $16 BN, with an estimated half of the wealth stock shock affecting PR investors.
The fundamental role of the banking and financial system in providing access to capital for the development of the private sector was abandoned, with preference granted to funding the government and lending to housing real estate and household consumption as if the business sector had no major structural challenges nor deserved new capital access sources.
2006-2008 PERIOD
Puerto Rico experienced a sustained loss of 46,884 jobs during CY2006 thru 2008 or three times those lost during CY2002 as a consequence of the 2001 global and local recession. Monthly data confirm widening total employment variations as high as 112,672 from a December 2004 peak to its lowest level in July 2008. As a result of the growing public finance risks here presented, during CY 2009 Puerto Rico was to receive its strongest contraction with a total net loss of 46,565 in total employment –similar to that of the 2006-2008 period of analysis- but in only one year.2 See Graph 1 and Table 1.
2 The analysis period of this Expert Witness Report ends in calendar year 2008 and/or Puerto Rico Fiscal Year 2009.
Establishment Survey data, Quarterly Census of Employment and Wages, US Department of Labor, Bureau of Labor
Statistics.
3
Graph 1
Table 1
Compared to same month of the previous year, total employment dropped in 35 out of 36 months during period of 2006 to 2008, as presented in Graph 2.
1,007,919
992,529
1,023,102
1,043,949 1,048,004
1,036,802
1,016,362
1,001,120
960,000
970,000
980,000
990,000
1,000,000
1,010,000
1,020,000
1,030,000
1,040,000
1,050,000
1,060,000
2001 2002 2003 2004 2005 2006 2007 2008
Puerto Rico, Average Annual Establishment Employment
Total Manufacturing Construction Services State Govt Other
2003 30,573 (814) 1,560 24,191 1,006 4630
2004 20,847 930 (80) 15,900 589 3508
2005 4,055 (2,446) (2,610) 12,144 (2,145) -888
2006 (11,202) (5,106) (3,186) 2,167 (2,198) -2879
2007 (20,440) (4,326) (2,858) (3,119) (7,661) -2476
2008 (15,242) (5,467) (5,154) (6,694) (1,213) 3286
2009 (46,565) (9,799) (13,188) (15,279) (1,071) (7,228)
Source: US Dept. of Labor, Bureau Labor Statistics, QCEW
Change in Employment, Establishment Survey
4
Graph 2
Non-housing private investment dropped by $660M or 37% between FY04 to FY08, along with government current spending, while net banking system net credit concession also contracted starting in March 2008. The contraction in employment, investment, government spending and the rate of growth and structure of bank lending is directly correlated to the banking system increase in past due and non-accrual loans (PDNA). See Graph 3.
Graph 3
Employment (Right Scale), Net Loans and Leases (NLL), PDNA (30-90) and (90+) December 2001=100
Deficits in the commonwealth’s (central government) fiscal accounts began to widen in the late 1990s, and between 1999 and 2004, central government expenses grew faster than tax revenues. These persistent deficits increased the Island’s public debt and led to questions about the sustainability of its fiscal policy.
-30000
-25000
-20000
-15000
-10000
-5000
0
5000Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
35 months of employment lossesMonthly YOY Change
2006
2007
2008
0.92
0.94
0.96
0.98
1
1.02
1.04
1.06
1.08
0
1
2
3
4
5
6
7
8
9
Dec.
20
01
Sep. 2
00
2
Jun.
20
03
Mar.
20
04
Dec.
20
04
Sep. 2
00
5
Jun.
20
06
Mar.
20
07
Dec.
20
07
Sep. 2
00
8
Jun.
20
09
PDNA (30-90)
PDNA (90+)
NLL
Employment
5
While debt growth moderated somewhat in the mid-2000s, Puerto Rico’s government bonds at the end of 2005 were rated just barely above noninvestment grade. Since then, a number of efforts have been made to restructure the Island’s fiscal operation, but they are a drain on disposable incomes and corporate revenues. An early response was the significant downsizing of government employment that began in 2007 that as we have discussed before, coincided with a deterioration of banking system loan credit quality.
Graphs 4 thru 6 confirm the extent of fiscal fragility by identifying the multiple revenue and expenditure transactions undertaken during the 2005-2009 period and the increase in public debt. Despite all of these measures and the adoption of new taxes, a structural deficit in excess of $1 BN continued. This reality has affected the closing balances of the General Fund and the Governmental Funds (see CAFRs).
Graph 4
General Fund, FY 05 thru FY09 Actual for FY05 thru FY08, Budget for FY09
Source: Treasury, GDB and OMB Commonwealth Credit presentations
6
Graph 5
General Fund, FY 05 thru FY09
Source: Treasury, GDB and OMB Commonwealth Credit presentations
7
Graph 6
Increase in PR Public Debt
Source of Graph: May 3, 2011 GDB Presentation before Joint Senate-House Treasury Committees on F12 Budget page 99.
Debt figures were released annually by GDB, in addition to individual bond issues.
Inverted Yield Curve makes interest spreads narrow, rising banking system vulnerability at a time of rising internal risks.3 Banks borrow short-term deposits and lend at longer maturities. As see in Graph 7 (please follow text box 1 thru 4 order, marked in red), from 2001 to 2003 steepening curve increased bank interest spreads. But when short term interests are high, spreads narrow significantly. Thus margin compression narrowed starting in 2004, dramatically worsened in 2005 to reach an inverted yield curve in 2006 and 2007. 2006 is peak of inverted yield curve, which remained until 2007. It is critical to review how PR bank’s strategic and risk plans incorporated these potential changes, particularly given their deposit and debt cost structure and costs.
3 The discount function, which determines the value of all future nominal payments, is the most basic building block of finance and is usually inferred from the Treasury yield curve.
8
Graph 7
Yield Curve Shifts, 2001 thru 2007
Source: US Department of the Treasury Resource Center http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield
Graph 8
Source: FDIC
-200,000
0
200,000
400,000
600,000
800,000
1,000,000
1,200,000
US $
Income of All PR Banks CY 2001-2008 YTD
Cashdividends
Netoperatingincome
9
PR Banks continued to sell and securitize 1-4 residential family loans, in the midst of the Global Financial Crisis, shedding risk off to institutional investors. Had they not done so, their financial condition would have been further affected. From CY 2001 thru 2005 PR banks sold and securitized consistent amounts in the $4.1-4.6 BN range, but activity increased to $5.5BN, $6.5BN and $9.7BN in CY 2006, 2007 and 2008, respectively. Privately issued mortgage-backed securities private issuance increased from a level of $700M in June-September 2006 to a $1.8BN during December 2007 thru June 2008.4
Despite multiple internal and external systemic risks, from year-end 2005 to year-end 2008 real estate loans increased from $31 BN to $43BN or from 54% to 68% of all Puerto Rico banking system loans. From 2005 thru 2007 Puerto Rico banks increased construction and land loan volumes. As seen in Graph 9 below the credit quality of these loans worsened all throughout the 2006-2008 period, reaching 16% total PDNA by December 2008. In other words, PR banks increased their exposure to real estate loans at the same time the real estate market was showing serious signs of distress.
The number of New Housing Unit permits declined every year since 2003, while the average price housing unit value increased 43% between FY03-FY08. Therefore late-entry developers were attempting to sell costlier units, seeking higher profits in a quickly deteriorating riskier environment
Graph 9
.
Structure of the Report. The key drivers behind pre-2006 employment growth are presented in the Report’s Introduction ahead, followed by a year by year analysis of 2006, 2007 and 2008 on how the banking system total loans level and increase in real estate loans.
4 FDIC Statistics on Depository Institutions, http://www2.fdic.gov/SDI/
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
18.00%
PDNA (ALL): Realestate loans indomestic offices
PDNA: Securedby non farmnonresidential
PDNA:Construction andlanddevelopment
PDNA: Securedby 1-4 familyresidentialproperties
PDNA of all Real Estate Loans in domestic offices (Dec. 2004 - Dec. 2008)
10
INTRODUCTORY REMARKS ON THE PRE-2006 PERIOD
PR is a highly leveraged economy; it consumes annually twice what it receives in compensation (See Graph 10, data for Fiscal Year (FY) 2006), financed with debt to be repaid from future earnings and taxes as well as by borrowings backed by pledged collateral (real estate, securities) that started losing its value and was subject to a profound shift in massive investment subsidies (the 1996 elimination of US Treasury tax credit program) and sudden losses or wealth shocks (bank stocks).
Household finances rely on increasing real estate value appreciations and equity extraction to consolidate household debt, finance consumption or investment in the primary or secondary real estate. But household’s key financing strategy was extended due to low interest rates, ample credit concession, real estate and construction boom, rising government expenditures and real estate values, even though investment and true structural economic conditions worsened.
Puerto Rico’s economic, fiscal and financial system performance after the 2001 recession up until 2006 was not sustainable. On the contrary, it was the result of a massive public finance and bank credit funded real estate bubble, neglecting rising structural risks to economic, fiscal and financial system stability performance and destroying the real estate and savings wealth stock.
Graph 10 Puerto Rico Total Compensation and Uses of GNP, Fiscal Year 2006
Source: PR Planning Board, National Accounts, Statistical Appendix Tables 2 and 11
Its large biopharma-led export sector (exposed to patent expiration risks and poor R&D capital allocation since the late 1990s5 still needs deeper local linkages, further growth and diversification, particularly since it imports such a high amount of goods and industrial inputs and consequently has a large negative trade balance. Its locally-owned private sector is too small and inward-looking compared to its large and inefficient public sector. More importantly, even though from 1997 to 2005, 40,530 manufacturing jobs were lost, a reduction of 26 percent of total manufacturing employment, PR never developed or implemented a strategy to address the elimination of US Internal Revenue Code Section 936 massive tax credits to US multinational investment, never lowered its operating costs, nor increased the quality and relevance of its
5 Puerto Rico is the US jurisdiction most exposed to Pharma poor allocation of R&D capital and patent expirations, referred to globally as the “lost decade of innovation”. See Appendix 1. As of 2009 it had 25% of US chemical manufacturing compensation, a result of production concentration subsidized by a US tax credit program during the 1976-1996 period. The 1993 cost to the US Treasury was $5.8BN, the peak year of the program, by 1997 it had been reduced to $3.2BN. See page 4, United States Government Accountability Office, Report to the Chairman and Ranking Minority Member, Committee on Finance, U.S. Senate, PUERTO RICO, Fiscal relations with the Federal Government and Economic Trends during the Phaseout of the Possessions Tax Credit, May 2006. GAO-06-541. GAO revised the Report in June 14, 2006. The US Dept. of Commerce’s Bureau of Economic Analysis prepares US GDP by State. please see http://www.bea.gov/iTable/iTable.cfm?reqid=70&step=1&isuri=1&acrdn=1
11
education and research to support emerging or growth stage ventures (local or external) even in areas of perceived global competitive advantage. Finally, Puerto Rico lacks comprehensive land use and infrastructure controls securing rising real estate values, the anchor point of savings and wealth. Therefore the structural risks of Puerto Rico are such that it could not afford entering into locally-generated economic, fiscal and financial system imbalances. But that is precisely what clearly occurred well before 2006 and intensified during 2006-2008.
As a result of excessive government spending, public debt6 (used to create government jobs7, finance deficits and poorly selected infrastructure projects) and bank credit concession to real estate, it went increasingly out of balance between
1. its private and public sectors, 2. the export and local market segments of the economy, 3. real estate loans and remaining banking system loans, 4. overall financial system resources and intermediaries specialized in growing the export-oriented
private sector.8
Investment
The main evidence of the unsustainability of the pre-2006 period is the deterioration in private industrial and commercial investment between FY00 and FY05 (Graph 11), when it dropped by $925M or 37% during these five years. Bear in mind that three large biologics investments took place during this period (Amgen, Lilly and Abbott led by the pioneer 0% income tax rate approved in 2002). Without them, the drop in private industrial and commercial investment would have been even greater.
Graph 11
Source: PR Planning Board, Statistical Appendix, Table 8, Gross Fixed Domestic Investment
6 See Appendix 2 for an overview of categories and repayment resources. 7 Combined state and local (municipios) employment creation between 1997 and the 2004 peak year was slightly over 26,000. See Appendix 3, for State and Local Government Establishment Employment in Puerto Rico until 2005. 8 GDB had granted priority to financial system restructuring in 1993, prior to the elimination of US IRC Section 936, when it commissioned the Arthur D. Little Report. Most of its recommendations were not implemented and, in contrary, the high exposure of local mutual funds, IRAs and insurance reserves to government debt prevailed.
2,872.5
2,245.3
2,062.9
2,503.3
1,578.2
750
1,250
1,750
2,250
2,750
3,250
$ M
Construction Segments. 1996-2005Gross Fixed Domestic Investment Current $
Public Total
Private Housing
Private Industrialand Commercial
12
We will expand further ahead on the challenges of Puerto Rico’s private sector development, but it is critical to understand that the PR banking system, the remaining private sector and the government failed to understand the implications and, even more importantly, react to this structural deterioration and imbalance.
The reduction in private industrial and commercial investment was masked by an increase in total exports and total employment and wages, but they were coming, respectively, from old products that were to lose their patent protection and additional jobs from services fueled by the real estate boom and the public sector. Government payroll expenses grew from $3.7 BN in FY01 to $5.1BN in FY05, or 6% annually, while General Fund revenues barely grew by 1%.9
Private housing investment peaked in FY02 at$ 2.25 BN and had dropped since then to $2BN in FY05. In contrast, the growth in public investment was one-third higher, financed by debt issuance and compromising GDB liquidity was significant: it peaked at $2.9bn in FY05, a level it had not reached since FY98.
The number of New Housing Unit permits declined every year since 2003, while the average price housing unit value increased 43% between FY03-FY08. Therefore late-entry developers were attempting to sell costlier units, seeking higher profits in a quickly deteriorating riskier environment. This is of critical important to the PR BANKING SYSTEM management of risks.
Employment, Wages and Disposable Income
The period leading up to and during the Loss Loans was one of profound change in the structure of total establishment employment in PR. PR’s productive economy shrunk to unacceptable levels. Whereas manufacturing employment shrunk by 40,530 or 26% between CY 1997 and 2005, CY01 thru CY05 brought significant increases in total employment according to the Household Survey. Wages also increased. See Graphs 12 thru 14.
Graph 12
Source: US Department of Labor, Bureau of Economic Analysis, Establishment Survey
9 See annual CAFRs as well as Puerto Rico Government Transition Fiscal Presentation 2008.
100000
110000
120000
130000
140000
150000
160000
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Total Puerto Rico Manufacturing Establishment Employment CY 1996 to 2005
as per BLS
13
Graph 13
Source: US Department of Labor, Household Survey
Graph 14
Source: US Department of Labor, Bureau of Labor Statistics, Quarterly Census of Employment and Wages
2001 was the peak year for unemployment insurance continued claimants (with over 55,000 claimants reporting no earnings) and 2002 was the peak year for initial claimants (with 17,330 new claimants).10
10 See Bureau of Labor Statistics, Extended Mass Layoffs (1999-2008) available on an annual basis.
1.085
1.105
1.125
1.145
1.165
1.185
1.205
1.225
1.245
1.265
Jan
Feb
Mar
Ap
r
May Jun
Jul
Au
g
Sep
Oct
No
v
De
c
Mill
ion
s
Puerto Rico Total Household Survey Employment CY 01-05
2001
2002
2003
2004
2005
6.1%
5.3%
6.0%
4.1%
2.7%3.1%
7.5%
5.4%
3.1%
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
1997 1998 1999 2000 2001 2002 2003 2004 2005
Percent Change Total Wages All Industries Puerto Rico CY 1997-2005
14
The high multiplier effect of manufacturing wages and purchases was sharply reduced.11 Public finances also started to be affected by tax revenues from a smaller base of manufacturing businesses, with less local purchases and spillover effects on incomes.
Public Financial Management
We have devoted particular attention to public financial management given that, beyond the fact the public sector accounts for a material share of total investment, employment and wages, there is no tradition of integrated analysis and risk management between financial and banking system, public finances and private sector structural challenges, particularly multinational investment.
The instability of central government finances, which started during Governor Rosello, worsened materially during the 2001-2005 period. During FY02 the central government increased overall operational spending by $3.8 BN or 45%. Once debt service and capital outlays are included, the central government increased its spending by $5BN or 47%.12 On June 2002 S&P downgraded the GO rating. This should have been a major alert to the PR Banks Board of Directors and the PR financial community in general on the systemic risks potential caused by public finances and their unsustainability and the urgency required to protect PR investment portfolios, mutual fund, IRA savings and insurance reserves, all concentrated in government securities.13 But as we will see ahead, General Fund revenue increases downplayed deteriorating General
http://www.bls.gov/mls/archivedreports.htm accessed October 26, 2013 Note: Figures were sometimes revised, in all cases listed figure is the last reported by BLS. For a graphic representation of these series please refer to Appendix 4. 11 The top 200 manufacturing employers that closed during the 1996 to 2008 period confirm the loss of 85,000 jobs with an annual estimated annual payroll of $1.4BN or $17,000 in average annual wages over this period. The top 10 closings in terms of job losses were StarKist Caribe in Mayaguez, Intel in Las Piedras, Hanes Menswear in Ponce, Motorola in Vega Baja, P.L. Industries in Mayaguez, Pan Am Shoe Company in Ponce, Sensormatic Electronic in Aguadilla, Bumble Bee Tuna also in Mayaguez, Johnson and Johnson OMJ Pharmaceutical in Manati and Propper in Mayaguez. Lockwood Financial Advisors Corp. analysis of BLS Quarterly Census of Employment and Wages employer data. 12 Source: CAFR FY2002, note 4 at pages 64-67. Starting with the FY2002 CAFR the Government of Puerto Rico prepared its financial statements according to the GASB Statement No. 34. This statement establishes new financial reporting standards for state and local governments and represents a significant change in the financial reporting model. A comparison between governmental funds financial statements prepared prior to GASB 34 and those after (i.e. FY01 and FY02) should be possible, as there was no change in the presentation, measurement focus, and basis of accounting of funds. The major changes identified were the reclassification of some nonmajor funds as blended component units of the central government, instead of being reported separately. As for the enterprise funds, some were reclassified and for others there was a change in the reporting entity. However, there were major reclassifications regarding the capital projects funds and the trust and agency funds. Comparability of other sections of the financial statements are affected, since there were changes in fund types and elimination of account groups. The new government-wide financial statements are prepared using the accrual basis of accounting and the economic resources measurement focus.
As a result, fund reclassifications and adjustments to the fund equities reported in the prior financial statement balances were required. The GASB 34 also requires a reconciliation between these government-wide financial statements and the fund financial statements. 13 Recent IMF research on fiscal multipliers confirms that government payroll and employment reduction has higher adverse effect that previously thought, particularly when net credit concession is restricted (Fiscal Multipliers). See IMF Working Paper, Fiscal Affairs Department, The Challenge of Debt Reduction during Fiscal Consolidation, prepared by Luc Eyraud and Anke Weber, March 2013 http://www.imf.org/external/pubs/ft/wp/2013/wp1367.pdf
15
Fund and Government Fund balances (as per CAFR), lower interest rates allowed for debt refinancing savings (Graph 15) and the 2001-2002 increases in GDB liquidity following large clean-up of GDB loans converted into long term debt -all mistakenly reduced the level of concern. On top of central General Obligation, appropriation debt and revenue bond issuance, both the central government and public corporations took on large GDB advances to boost public investment, betting that they could reimburse GDB with future bond issuance. In fact, they were compromising GDB while increased overall debt.
Graph 15
In May 2005 Moody’s and S&P each had announced downgrades to the Commonwealth GO debt rating, from Baa1 to Baa2 and from A- to BBB, respectively, due to concern over Commonwealth financial performance, budget structural imbalance, low funding ratio of the ERS, uncertainty on the FY06 budget approval and availability of additional recurring revenues. One further downgrade meant that $4.3bn in appropriation debt was to fall below investment grade for the first time ever.
During FY05 GDB had a combined loss of $359M due to the $500M dividend to the Special Communities Trust.14 In addition to the $957M FY03-FY05 deficit loans above GDB had granted $2.2BN in advances for capital investment to stimulate the economy, to be repaid from future GO bond issuance in addition to the $2.1 BN in GO’s issued since FY02.
Banking System
Therefore, given that Puerto Rico consumes annually twice what it receives in compensation, it is important to stress the fact that increased instability in household, public finances and manufacturing translates into major intra-PR systemic risk of major credit deterioration. It was within this environment that many PR banks increased its real estate lending. The overall deterioration led to a full halt in net credit concession starting in March 2008, which further affected overall performance of businesses and the public sector.
14 GDB FY06 FS Note 3, page 36.
16
Graph 16
Source: Lockwood Financial Advisors Corp., FDIC, PR Planning Board
PR’s banking system net loans and leases increased from $31BN in December 2001 to $56.4 by December 31, 2005 and then to an all-time historic peak of $62BN in March-September of 2008.
The share of real estate loans increased from 52% to 70% of net loans and leases or by $27BN during this period, despite all the risks disclosed in this expert witness report. For example, lending in its construction loan department increased from $79.6 million as of March 31, 2005, to $184 million by September 30, 2007. By September 30, 2009, lending by the construction loan department had increased by another $48 million to $232.5 million.
17
Graph 17
Source: FDIC
Graph 18
Source: FDIC
47,500,000
49,500,000
51,500,000
53,500,000
55,500,000
57,500,000
59,500,000
61,500,000
63,500,000
PR Total Banking SystemNet Loans and Leases
-1,000,000
4,000,000
9,000,000
14,000,000
19,000,000
24,000,000
29,000,000
34,000,000
Dec.2001
Jun.2002
Dec.2002
Jun.2003
Dec.2003
Jun.2004
Dec.2004
Jun.2005
Dec.2005
Cu
rren
t $
Overexposure to Real Estate Loans
Commercial andIndustrial Loans
Loans to Individuals
All real estate loans
Other
18
Credit quality problems with total banking system real estate loans started in 2005 (Graph 19) when the 30-89 days PDNA doubled, precisely at the time of increasing public finance uncertainty given the central government deficit, credit rating downgrades and lack of consensus on the F06 budget .
Graph 19
Source: FDIC
Starting in 2004 PR bank equity analysts started reviewing their estimates downward. 2005 earnings were down 22% to $1.149 BN by year end as GNP growth dropped to 1.9%, Doral and FirstBank were required to restate financial statements and the Federal Reserve increased interest rates by 200bps. Besides PR government bonds and AFICAs, bank stocks are the only remaining private securities available to comply with the requirement investment thresholds of local mutual funds, IRAs and insurance reserves.
As a result of the perceived economic environment and impact on banking system loan growth, loss reserves and earnings, by year-end 2005 the PRSI lost almost half of its December 2004 peak value. See Graph 20 below. Therefore the bubble burst’s first events occurred during CY05.
19
Graph 20
PR Stock Index December 1995 to December 2005 December 1995=100 for both PRSI and S&P 500
Source: Government Development Bank, Economic Matters
The following concerns were expressed by Moody’s in its PR Banking System Outlook July 2005; Interest rates: flattening of yield curve compresses NIM: “Pricing competition is compounding the banks' funding challenges and has impacted overall profitability. Specifically, robust growth in the banking sector, particularly in terms of asset growth, has meant that the sector has experienced a higher growth rate than the Puerto Rican economy as a whole. In order to maintain that growth, the local banking environment has become more competitive with regard to pricing competition. In particular, in recent years, many of the banks have competed along IRAs, CDs, and other retail deposit product lines, as well as for a number of loan categories, including residential mortgages and large commercial relationships. Moody's believes that as a result of the competitive dynamics highlighted above, net interest margins would be challenged in any rate environment, but may be more challenged in the current interest rate environment. In the near term, Moody's expects that the rise in short term rates, combined with the drop in long term rates, which has resulted in a flat yield curve at relatively low levels, may not be easy for the banks to manage. Unique deposit market…The Puerto Rico deposit market is more challenging than the deposit market on the U.S. mainland. Puerto Rico has a relatively stable population base, a number of very competitive local banks looking to expand, and a large proportion of citizens, perhaps 50%, that do not have bank accounts. As well, the difference between the tax rates on interest earned from bank deposits, versus the much lower tax rate on returns from investments held in local mutual funds makes those funds more attractive to some investors. These dynamics present significant challenges for gathering and retaining core deposits. Of the rated banks, only Banco Popular de Puerto Rico has a core deposit to loan ratio in excess of 100%. In addition, over 100 credit unions, some growing rapidly, are active on the island. The result is a very high cost deposit market, to the extent that brokered CDs from the mainland are significantly cheaper than most on-island deposits. We do not expect this dynamic to change. Though the banks have proven adept at exploiting a variety of non-traditional funding sources, such as preferred stock and brokered CDs, the lack of a robust core deposit market in Puerto Rico hurts net interest margins relative to mainland banks with similar businesses.”
“Therefore, many of the dynamics which define the financial health of the Puerto Rican banks are linked to the political process at the Commonwealth level and the impact of that process on the local economy.”
693
367
0
100
200
300
400
500
600
700D
ec-
95
Sep
-96
Jun-9
7
Ma
r-98
Dec-
98
Sep
-99
Jun-0
0
Ma
r-01
Dec-
01
Sep
-02
Jun-0
3
Ma
r-04
Dec-
04
Sep
-05
P.R. Stock Index (PRSI) S&P 500 Index
20
In November 2005, near-term risks to Puerto Rican bank stocks included the following:
1. “NIM compression due to rising interest rates; 2. decline in real estate prices, which could be facilitated by a slowdown in the economy, or a rapid
shrinkage of the "demand versus supply" housing gap; 3. a potential tax hike to reduce the government deficit; and 4. the potential for current FAS 140 issues at Doral, R&G, and First Bancorp to be a wider issue in
Puerto Rico.” 15
“The major long term risks include the fact that business activities and credit exposure for Puerto Rican banks are concentrated in Puerto Rico. Consequently, their financial condition and results of operations are dependent upon economic conditions in Puerto Rico, as well as changes in legislation on the island, which could eliminate many of the tax advantages these banks currently receive.”16
Conclusion
Therefore the pre-2005 state of the Puerto Rican economy can be clearly characterized as fragile and its priorities lacking strategic direction. Instead of growing and diversifying the productive sector, we channeled a historically high level of private investment, banking system credit, public debt and tax resources to intensify systemic risks by investing in bank equities, real estate, government debt to finance poorly selected public investments and higher governmental expenditures.
Deep internal structural risks clearly started well before the May 2006 government closing officially marking the beginning of the recession. Evidence of compounding risks were clearly available to all –specifically interlocking unsustainable booms fueled by large public infrastructure projects since the late 1990s, excess government expenditures financed by debt and imprudent growth in bank credit concession: all fueling PR bank stocks bubble and real estate asset bubbles. Any due diligence undertaken by PR banks to continue to grow their real estate portfolios in 2006, 2007 and 2008 underestimated these risks.
External US and global risks were also rising prior to 2006 and were bound to complicate matters even further for Puerto Rico. Experts at the IMF, for instance, pinpointed household mortgage risks in a scenario of significant real estate devaluation, and outlined during 2005 a script of the key developments to occur during the 2006-2008 period:
“Policies designed to improve the financial stability of systemically or otherwise important institutions need to also consider the consequent flow of risks to households and their ability to absorb or manage such risks. Households are relevant to the financial stability debate in numerous ways, including the following considerations:
1. potential public sector costs related to household shortfalls in long-term saving and investment; 2. the broader role of government as “insurer of last resort”; 3. the need to facilitate or more actively develop markets and market solutions, or alternatively, to re-
regulate institutional behavior to achieve the desired risk sharing; 4. moral hazards, for example, from excessive risk taking by institutions based on the belief that
governments will support market values in an effort to protect household balance sheets (i.e., markets are seen as “too important to fall”); and
5. the impact of more direct risk exposures on household behavior, including consumption and saving
patterns.”17
15 First Bancorp's announcement that mortgages bought from R&G (RGF) did not qualify as sales under FAS 140, analysts were concerned if the atypical contract terms offered by Doral and R&G to their local peers could result in a wider FAS 140 issue in Puerto Rico. 16 UBS Investment Research, Puerto Rican Banks, Could FAS 140 be a Systemic Issue? 4 November 2005, authored by Omotayo Okusanya, II, CFA. 17 International Monetary Fund, Global Financial Stability Report, Market Developments and Issues, April 2005, pages 63-64. For a Summary of 2002-2005 GSFR See Appendix 6.
21
PR Economy 2006-2008 During the years 2006-2008, rising risks confirmed a marked global and internal credit deterioration in many markets including PR. The analysis and evidence demonstrating this fact will be presented for each year, following this structure:
1. Summary Key Findings for Year 2. Global Financial Stability 3. Investment and Construction Indicators 4. Employment, Wages and Disposable Income 5. Public Financial Management 6. Puerto Rico Banking System Performance
2006 RISKS
Summary of Key Findings
The global financial community alerted on the rising risks of derivates structured with underlying subprime mortgage assets. Furthermore, any sudden rises in interest rates would destabilize household finances and wealth stock, affecting the debt-service to income ratios of households and the credit quality of these derivatives.
In PR, highly leveraged household finances would be primarily destabilized by the overall economic, investment and employment and wages slowdown. Private investment, banking and overall financial system were taking a passive role regarding the growth of the private sector in productive activities. Instead, all focused on real estate. At this time, PR was already experiencing a reduction in all investment categories except private housing, but the number of authorized housing units was declining and the average price of housing increasing. Therefore, market entrants were seeking higher margin projects for higher income categories that were exposed to the wealth shocks from bank stocks, government securities and real estate itself. During CY 06 employment dropped for the first time since the 2001 recession and confirmed that the reduction was comparable to the (-15,390) loss during CY02. PR banks evidently saw that public finances were deteriorating sharply. During 2006, the PR government disclosed FY05 as the 4th consecutive year of worsening central government General Fund deficits, even after GDB loans to the Commonwealth for $250 million, $233 million, and $550 million from FY03 to FY05, to cover the estimated Commonwealth’s budget deficit -and in addition to all savings arising from debt service refinancing.
2006 was characterized by the government shutdown (a shock to investor’s confidence and the local payment system) and wide discussion on how to impose a broad based consumption tax, increase recurring revenues and control spending to eliminate the structural budget deficit by fiscal year 2008. Such increases in revenues were questioned by credit rating agencies and they downgraded the government for the third time since 2002. The new sales tax and accompanying rate increases in utilities would also reduce disposable income as employment and wages were slowing down.
The constraints of the local private sector became evident. FY06 tax revenues from taxable companies were down by-35%, a major risk indicator of shrinking margins, losses and overall drop in demand due to the economic slowdown. Only 70-80 taxable companies with more than $50M in gross income during the CY2001-2008 period accounted for an average of 46% of the total tax liability (TTL) of corporate taxpayers. Therefore, more importantly, PR banks could see that the central government and public corporations would be barely able to stabilize their operations, and therefore would not provide stimulus to the economy nor lead it to a path of overall return growth and employment creation.
Banks faced an Inverted yield curve, continued tough competition for asset, as most of the banks no longer relying on purchasing mortgages from the local mortgage originators. Organic loan growth has become a priority, with some banks aggressively pricing loans to attract volume. This puts pressure on other players to
22
also lower rates or risk losing business. Rating agencies became concerned that this practice resulted on loans not being priced adequately for risk, as it became increasingly common for unsecured consumer loans and commercial loans to be priced below the prime rate. Finally, there was continued tough competition for deposits, with the local mortgage originators offering the most attractive rates to shore up capital to run their businesses.
As of year-end 2006, the share of all real estate loans within total net loans and leases for the PR banking system increased from 54% to 61%. However, banks knew that a real estate-focused strategy for loan growth was extremely risky. Evidence included the sudden Sept 2005- Sept 2006 contraction in the volume of residential mortgage origination and deterioration of real estate and total loans, all indicating deep real estate restructuring challenges ahead. From December 2004 to March 2006 PR banking system real estate loans in domestic offices in PDNA status had increased for 6 consecutive quarters, from $523M to $1.1BN or by 117% However, it was precisely during this period that PR banks increased their exposure in construction and land development loans: from December 2004 to December 2006 their share of all real estate loans imprudently increased from 11% to 17%.
By the end of CY06 PR banking assets in non-accrual status increased by 104% compared to year end 2004, reaching $1.3BN and those in the 30-90 day PDNA segment by 96%, reaching $1.4BN. See Graph 37. CY06 total PR banking system net charge offs reached $314M, up 32% from the previous year, and total banking system net income was $652M or 30% less than CY05. By March 2006 PDNA Loans to individuals and other consumer loans had also worsened for 8 consecutive quarters.
Analysts’ concerns with PR bank stocks still being 17-55% overvalued persisted, based on deteriorating credit quality and subpar loss reserves. Both analysts and credit rating agencies alerted on the possibility of a long term deterioration in asset quality of banks due to a prolonged economic recession.
Global Financial Stability
The IMF Global Financial Stability Report (GFSR), initiated in 2002, is the most important and comprehensive monitoring of the global financial system, addressing structural or systemic issues relevant to international financial stability. It is a required reference for PR banks to monitor the external environment.
One year before the Global Financial Crisis officially started18, the March 2006 GFSR alerted the global financial community of the high probability and consequences of a Lehman-type of event, based on the following risk concerns:
a. contagion from complex derivatives and new institutions that had shed the credit risks historically contained in bank balance sheets
b. rising concerns with subprime mortgages c. an understanding that accumulation of U.S. dollar assets by the rest of the world at the scale
registered up until 2006 could not go on forever
We have summarized the following seven reasons behind the strong IMF alert:
First, global credit derivatives outstanding had grown from about $4 trillion at year-end 2003 to over $17
trillion at year end 2005, exceeding the stock of corporate bonds and loans. Most growth occurred in
18 The first Global Financial Crisis events identified by the Federal Reserve bank of St Louis are (1) the February 27, 2007 announcement by the Federal Home Loan Mortgage Corporation (Freddie Mac) that it would no longer buy the most risky subprime mortgages and mortgage-related securities; (2) the April 2, 2007 SEC filing by New Century Financial Corporation, a leading subprime mortgage lender, announcing its filing for Chapter 11 bankruptcy protection; (3) the June 1, 2007 Congressional Testimony by Standard and Poor’s and Moody’s Investor Services discussing its decision to downgrade over 100 bonds backed by second-lien subprime mortgages; (4) the June 7, 2007 Bear Stearns notification to investors that it was suspending redemptions from its High-Grade Structured Credit Strategies Enhanced Leverage Fund; and (5) the July 11, 2007 Standard and Poor’s Ratings Direct announcement of decision to place 612 securities backed by subprime residential mortgages on credit watch.
23
developed economies in complex products such as credit default swaps (CDS), referencing more than one
credit name (i.e. portfolio swaps) and is associated with the growth of hedge funds that arbitrage intra- and
intermarket anomalies and transfer credit risk, particularly thru the sale of equity or ‘first loss tranches’ with
a credit rating. The analysis and rating of structured credit products heavily relied on sophisticated
quantitative modeling, making the application of such skills “more important than the fundamental credit
analysis and thus a cause for concern”.
Second, GFSR highlighted that “structured credit products are likely to suffer more severe, multiple notch
downgrades relative to smoother downgrades of corporate bonds (page 61) and encourages rating
agencies to better understand how such ratings may be expected to perform through the credit cycle”.
Third, due to rising concern with sub-prime mortgages: “The main vulnerability in the U.S. mortgage markets at present lies more in the sub-prime segment of the market. Many sub-prime borrowers in these new instruments intend to refinance fairly quickly to take advantage of any house price appreciation and to avoid refixing at higher rates. However, rising interest rates, a cooling-off in the U.S. housing market, and regulatory tightening, all of which would make it more difficult for these borrowers to refinance if they cannot otherwise qualify for a traditional mortgage, mean that many will be trapped in the original reset terms of these mortgages. An estimated $140 billion of such mortgages are due to be refixed in 2006, and $350 billion in 2007. The result is that the delinquency rate in this market segment will probably rise. Anticipating this, spreads on asset-backed securities (ABS) using sub-prime mortgages and on collateralized debt obligations (CDOs) including or referencing such ABS have widened substantially (Figure 1.15). Since these markets are new, there are concerns about whether investors, especially new entrants, fully understand the risk and have the capacity to adequately manage it.” Fourth, due to the concentration of dealers in derivatives and potential disruptive impact of the withdrawal
of a major dealer. Although the GFSR consistently portrayed as a positive the wider dispersion of (subprime
mortgage) risks as a result of securitization away from bank balance sheets, therefore increasing the shock-
absorbing capacity of the financial system, “by not requiring a small number of systemically important banks
to provision for nonperforming loans, at the same time it alerted that the concentration of dealers in credit
derivative products was a potential source for vulnerability. Many surveys indicate that the top 8-10 global
dealers continue to have a large and relatively stable share (approximately 70%) of total gross positions
over the last several years. “surveys also show that the degree of concentration varies considerable across
products and that the concentration among the top or three dealers is much lower than in the past, with no
single firm dominant in all or even most credit markets”….”nevertheless, the withdrawal of a major dealer
(i.e., the 2008 Lehman event), while unlikely in view of the infrastructure commitment, revenue contribution
and their solid credit rating standing, would have a disruptive impact on the market, at least in the short
term.”19
Fifth, given that liquidity in single name CDS, arguably the most efficient way to hedge a specific credit
exposure, tends to evaporate quickly with increased market volatility, even for the most liquid names.20 In
contrast with Basel I, Basel II increases incentives to sell higher-risk assets, and increases the influence of
market measures on required capital.21
Sixth, because such an event would affect small banks, such as those of Puerto Rico: “smaller banks, according
to the Federal Reserve Boards’ US commercial bank surveys, accounted for half of real estate and consumer
lending and are were not very active in risk transfer markets.22 Thus the assumption that transferring credit
19 IMF, GFSR, March 2006, page 65. 20 Op. cit., pages 66-67. 21 Op. cit., page 58. 22 Op. cit., page 62, note 23.
24
risk from (large) banks to capital markets, help make the banking system, including smaller banks, less
vulnerable to credit shocks” proved to be mistaken.23
And finally, because a change in interest rates was a highly probable scenario, affecting the debt-
service to income ratios of households, which in Puerto Rico are higher. “Higher interest rates could
raise the debt-servicing burden of homeowners—at present, the debt-service-to income ratio for the
household sector is already at a high level of 13.5 percent. This could worsen the credit quality of the
mortgage markets (particularly subprime mortgages to be reset 2006 and 2007) and result in losses for the
lending institutions.”
Therefore the GSFR did present the risks arising from sub-prime mortgages derivatives to global banking system risk management, and moreover, they recommended integrating them to flattening and inverted yield curve scenarios. PR banks continued to securitize and well assets and access brokered deposits. But given lower household income levels, rising interest rates, lower wages and employment levels starting in 2006 the overall adverse global environment was to block exit strategies for PR banks. These adverse global events eventually affected the Puerto Rico banking system, when in year-end 2008 Banco Popular could not access capital markets and had to rely on an investment from the GDB and EDB.
Investment and Construction Indicators, 2006
This section relies on two sources of information available to the PR banking system: the annual fiscal year estimates for Gross Fixed Domestic Investment, one of the national accounts, and the monthly Construction Indicators, which feed from permits and supplementary annual surveys, both issued by the PR Planning Board.
Annual macroeconomic forecasts prepared by the Planning Board and private economists rely on total investment estimates. But starting in FY06, the Planning Board started to present significantly overly optimistic forecasts, which should have been questioned and adjusted by the banking system for loan growth demand and risk management purposes. During FY05, FY06 and FY07, the original GNP estimates were 2.7%, 2.5% and 0.6% while their own revised estimates were subsequently adjusted to 2.0%, 0.5% and -1.9%. See Graph 21.
Graph 21
Source: PR Planning Board
Given that the GDFI is more comprehensive and is solely presented on a PR fiscal year basis; thus we will start our analysis with this source and present up to FY07, given that it includes the July-December 2006 semester. GDFI includes both construction and machinery and equipment, but the following graphs and
23 Op. cit., page 63.
25
analyses only address construction. All graphs and figures here presented are in current dollars, in order to avoid the controversy on deflators used by the PR Planning Board and their methodology and their divergence from the Consumer Price Index. Nevertheless the reduction trend is evidently clear. Any adjustment to real dollars would make the contraction even deeper.
FY07 was the 7th consecutive year of declining private industrial and commercial construction investment, from a peak of $2.5BN in FY00, this segment reached $1.5BN by FY05 and $1.1BN in FY07. See Graph 22. We have stressed the structural risks of the continued contraction in these non-housing private business-related investments leading to private employment and productive, export-related or import-substitution activity.
FY06 Private Housing Investment returned to FY02 levels, when Industrial and Commercial Construction investment had already dropped. As we will review ahead, rising risks from the external environment and internal drivers such as loan credit quality deterioration, public financial management, economic, employment structure, slow-down in wages and other sources were not being properly considered by private housing investors.
Graph 22
Source: PR Planning Board GDFI Table 8 Statistical Appendix
A review of Construction Permits further confirm rising risks with two additional trends: CY 2006 saw new housing permits continuing to drop but the average private housing value continued to increase. More expensive housing units were being proposed by developers and financed by PR banks. As we shall see ahead, besides the adverse investment levels presented before, there were adverse developments all across: in employment, wages and disposable income as well as public financial management, the shift towards an inverted yield curve, bank competition for assets and deposits, worsening loan credit quality and a drop in residential mortgage origination. Rising risks were being massively underestimated by both late-entry and often less sophisticated developers and by banks, the latter in a search for higher loan spreads, earnings and stock prices.
2,872.5
2,062.9 2,503.3
1,578.2
1,106.6 1,176.8
500.0
1,000.0
1,500.0
2,000.0
2,500.0
3,000.0
3,500.0
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
$ C
urr
ent
Construction Segments. thru FY 07Gross Fixed Domestic Investment
Public Total
Private Housing
Private Industrial and Commercial
26
Graph 23
Graph 24
14,000
14,500
15,000
15,500
16,000
16,500
17,000
17,500
18,000
18,500
2003 2004 2005 2006
Number of New Housing Units Authorized, CY 03-06
Number of New HousingUnits, CY
-800
-600
-400
-200
0
200
400
600
800
1000
Jan Feb March Apr May Jun Jul Aug Sept Oct Nov Dec
New Housing Units Authorized, Monthly 2005-2006
2005 2006 Linear (2005) Linear (2006)
27
Graph 25
Source for Graphs 23 thru 25: PR Planning Board
Employment, Wages and Disposable Income.
2006 was the fifth and last year after the 2001 recession with sustained increases in employment according to the Household Survey but the first year of employment losses (-11,202) according to the Establishment Survey, which is the most conservative source given that it comes from directly from employers and is confirmed with their unemployment insurance filings on total employment and wages. In fact, CY 06 employment loss under this source confirmed that the reduction was comparable to the (-15,390) loss during CY02 following the 2001 recession.
Following the Household Survey, the labor force increased by over 39,000 in CY06, its fifth consecutive growth year, though not as forcefully as in 2002 when it had increased by 48,000. During 2006 Household employment levels rose by almost 45,000 or 3.7%, peaking after six consecutive years of increases, and reaching an annual average of 1,269,360 or 139, 951 more jobs that the CY2001 average.
However, the Establishment Survey confirmed that total employment continued dropping and registered a reduction for the first time since post-2001 recession. See Table 2. Manufacturing employment contraction doubled in CY06. Construction employment dropped and its contraction should have been greater when considering that a large share of construction workers are part of the informal economy and paid in cash. Services (in bold) were no longer adding jobs to the economy: CY06 growth was minimal and the fourth consecutive year of contraction. Manufacturing employment losses accounted for 46% of the contraction during CY06, down -4% that year to a low of 111,066, based on the Establishment Survey. State government employment dropped for a second consecutive year.
Following the Establishment Survey series presented in Graph 26, it was clearly evident that since March 2006 (before the central government closure) employment started to shrink below the monthly 2005 levels. Year-end levels growth, typical due to retailing, were still below those of 2005. This should have been a major alert for the entire banking system. On an annual basis, therefore, compared to the previous CY, PR lost 11,202 jobs in 2006, and was to suffer another loss of 20,440 in 2007 and finally another 15,242 in 2008.
55
61 61
71
50
55
60
65
70
75
2003 2004 2005 2006
Average Private Housing Unit Value
28
Table 2
Graph 26
Puerto Rico Total Employment, Establishment Survey, Total All Industries CY 2002 thru 2006 by Month
By 2006 the rate of growth of annual establishment wages had decreased for the previous three years, from 7.5% in 2003 to 5.4% in 2004 and 3.1% in 2005, confirming a slowdown in disposable income. Wages data is disclosed quarterly. Consistent evidence of total employment reduction starting in 2005 and 2006 and slowdown in wages growth starting in 2004 should have alerted PR banking system directors.
Total Manufacturing Construction Services State Govt Other
2003 30,573 (814) 1,560 24,191 1,006 4630
2004 20,847 930 (80) 15,900 589 3508
2005 4,055 (2,446) (2,610) 12,144 (2,145) -888
2006 (11,202) (5,106) (3,186) 2,167 (2,198) -2879
Source: US Dept. of Labor, Bureau Labor Statistics, QCEW
Change in Employment, Establishment Survey
960000
980000
1000000
1020000
1040000
1060000
1080000
1100000
1120000
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
2002
2003
2004
2005
2006
29
Graph 27
.
Graph 28
Source: US Department of Labor, Bureau of Labor Statistics, Quarterly Census of Employment and Wages
Besides having the new sales tax erode $800M-$1BN in disposable income when wages were barely increasing, FY06 budget included $500M in new recurring taxes and savings measures as well as a hiring freeze, also affecting disposable income and public stimulus. Besides a 30% increase in the price of oil, which reduced disposable personal income, GDB and PRASA announced the end of a General Fund $200M PRASA debt service subsidy and a two-stage rate increase exceeding 100% in October 2005, also affecting disposable income. Therefore, as we shall see ahead, loan growth and credit quality started to become a challenge during CY06. It was also during the second half of 2006 that mortgage origination levels started to drop.
2.7%3.1%
7.5%
5.4%
3.1%
2.6%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
2001 2002 2003 2004 2005 2006
Total Wages All Industries Puerto Rico
Annual CY Percent Change
4,500,000
5,000,000
5,500,000
6,000,000
6,500,000
7,000,000
Qtr1 Qtr2 Qtr3 Qtr4
Cu
rre
nt
$
Quarterly Total PR Wages 2000-2006
2000
2001
2002
2003
2004
2005
2006
30
Public Financial Management
The Commonwealth of Puerto Rico Comprehensive Annual Financial Report (CAFR) is the primary means of reporting for the Commonwealth’s financial activities in a comprehensive and consistent manner.24 It includes the central government, public corporations, retirement systems and other entities, (except municipalities) and is presented to the Governor and Legislature by an independent auditor in conformity with US generally accepted accounting principles. The annual disclosure of the CAFRs are a fundamental event in public finance and macroeconomic risk management oversight and should have merited the highest priority by all bank’s management and Board of Directors.
Beyond the massive increase in government employment presented before, the FY05 CAFR was released in March 30, 2006 confirmed a deterioration and instability in central government public finances affecting overall economic, fiscal and financial system conditions, including real estate and banking system credit quality. The FY05 CAFR confirmed the following:
1. The central government General Fund deficit had grown to $511M in FY05 (Graph 29), compared to a deficit of $366 and $80M in FY04 and FY03. This FY05 was the 4th consecutive year of worsening central government General Fund deficits, even after GDB loans to the Commonwealth for $250 million, $233 million, and $550 million from FY03 to FY05, to cover the estimated Commonwealth’s budget deficit -and in addition to all savings arising from debt service refinancing. Larger audited deficits confirms persistently weak internal financial controls, accumulation of government payables and increasing GDB risks.
2. The broader Governmental Funds Balance (includes the General Fund and all other resources under the control of the central government, including federal funds which are referred to as intergovernmental, as well as debt service funds and assets of entities such as COFINA and the Children’s Trust) had also been quickly depleted: FY05 balance dropped to a mere $385M compared to $1BN and $856M in FY04 and FY03. In contrast, FY01 had closed with Governmental Funds and General Fund positive balance of $4 BN and $2.6 BN.
3. The key underlying events were the stagnation in General Fund revenues between FY03 and FY04 and an increase in expenditures (net of capital outlays and debt service) of $1 BN in FY04 and $1.3 BN in FY05. See Graph 30.
Graph 29
24 It is disclosed each year at the PR Treasury Department website and also filed with the Municipal Securities Rulemaking Board (MSRB) EMMA online system for public availability.
2,614,734
(511,271)
4,069,396
385,711
(1,000,000)
-
1,000,000
2,000,000
3,000,000
4,000,000
5,000,000
1999 2000 2001 2002 2003 2004 2005
PR Central Government Financial Deterioration (General Fund is a part of Government Funds)
General Fund Balance (Deficit) Governmental Funds Balance (Deficit)
31
Graph 30
Bickering on FY06 budget. Therefore PR BANKING SYSTEM could not expect fiscal stimulus, economic and loan demand growth from the central government, which faced increased tension and instability since,25 for the first time since 1968-1972, Executive and Legislative branches were under the control of different political parties.
The FY06 budget submitted by the Executive branch refused to reduce spending despite the existence of deficits since FY03. Instead, it had a 5.2% increase in expenditures, included revenue raising measures to cover this increase and included a $368M debt service refinancing of appropriation debt. It was not approved by the Legislature. An alternate budget of 9.258BN was vetoed by the Governor and the previously approved FY05 budget was rolled over for FY06, but with $130M in new revenues measures that had been proposed and approved for FY06.26 One of them was a special surtax on banks.
On November 200527 fiscal policy goal of a Joint Resolution was to impose a broad based consumption tax, increase recurring revenues and control spending to eliminate the structural budget deficit by fiscal year 2008. This would also reduce disposable income as employment and wages were slowing down.
Upon the elimination of the structural budget imbalance, the 2005 Joint Resolution assumed a return to robust macroeconomic and fiscal recovery, revenues and yet unsupported expenditure controls, given that it sought
25 “Deeply polarized political system impedes consensus on economic development and fiscal issues. Large size of Commonwealth government relative to the economy also reduces practical flexibility on fiscal issues” Moody’s Investor
Services, 22 May 2007 MOODY'S ASSIGNS Baa3 RATING TO APPROXIMATELY $1.5 BILLON COMMONWEALTH OF PUERTO RICO, PUBLIC IMPROVEMENT REFUNDING BONDS; OUTLOOK IS NEGATIVE. 26 The Commonwealth alerted to investors that “although the revenue-raising provisions contained language conditioning their effectiveness on the approval by the Governor of the $9.258 billion budget resolution, according to the Secretary of Justice, these revenue raising measures are enforceable regardless of such language. Although no legal action has been initiated thus far, no assurance can be given that the effectiveness of such revenue measures will not be challenged.” See $1,042,500,000s Commonwealth of Puerto Rico Tax Revenue Anticipation Notes Series 2006, December 22, 2005. 27 November 21, 2005 Joint Resolution 321 and Governor’s Fiscal Reform Executive Order implementing the Resolution imposed expenditure controls and established principles to govern the tax system (adoption of a broad-based consumption tax), fiscal policy and practices reform process.
7,000,000
8,000,000
9,000,000
10,000,000
11,000,000
12,000,000
13,000,000
14,000,000
15,000,000
16,000,000
17,000,000
1999 2000 2001 2002 2003 2004 2005
Cur
rent
$
Massive Growth in Central Government Expenditures
Central GovernmentTotal Revenues
Expenditures includingCapital Outlays andDebt Service
Expenditures excludingCapital Outlays andDebt Service
32
to “start an annual contribution to the public improvement fund equal to 2% of the total amount of bonds authorized for that fiscal year, which would increase by 2% per year to reach 20%”. 28
Moody’s correctly questions the ability to close the deficit. Despite not rating GDB and only planning to start doing so in the near future, Moody’s alerted in February 200629 that “the rate of spending growth in core programs (at 14% and 9% in 2005 and 2006) could once again exceed recurring revenue this year”. Furthermore, Moody’s stated that even if spending growth is slowed to 5%, balancing future budgets will be difficult, even assuming implementation of significantly revenue-positive tax reform” Therefore even “uncertain passage” of $800M-$1BN in tax reform revenue (sales tax-centered) revenues “there could still be additional painful measures required before structural balance is achieved”. Furthermore, Moody’s alerted that GDB “liquidity trend has been sharply negative over the last two years, as the bank has greatly increased its lending to the government…by liquidating investments and increasing issuance of GDB commercial paper, recently increasing its reliance on private sector institutional deposits, which we view as essentially a form of short-term and confidence-sensitive borrowing. A recent $885 M issuance of long term notes in the PR capital market has begun to stabilize the balance sheet.30 A net repayment of GDB loans to the central government was only to come with the issuance of COFINA debt in 2007.
FY06 GDP/GNP growth confirmed the third consecutive year of slower growth and Moody’s questions whether tax sales estimates would be attainable.31 “The Commonwealth's fiscal 2006 income and excise tax estimates look relatively robust in light of recent economic trends on the island, which remain subdued. Real GDP growth, for example, has been hovering at close to 2%, significantly slower than US mainland growth. In addition, private sector employment in Puerto Rico in the second half of 2006 was down more than 2% compared to the year-earlier period (based on preliminary estimates) with weakness spread across most sectors of the economy. This is occurring at the same time that government employment is falling, as discussed above. The island's trend of manufacturing closures continued in 2005, mainly reflecting globalization pressures on lower-skill, labor-intensive industries. The pharmaceutical and bio-tech industry continues to be a relative bright spot, however, with continued new plant investments and recent employment levels stable. We note there were a couple of merger-related pharmaceutical plant closures last year.32 Positive trends appear to be continuing in the tourism sector, with non-resident hotel registrations up about 3% in the first ten months of 2006 but little data available for the current peak season which began in November. The recent opening of a new convention center is expected to increase the island's visitor numbers, especially during the off-peak season, and to extend the trend of hotel construction in the San Juan area. Tourism is of moderate importance to the economy at present, but represents an opportunity for future growth. The employment figures are due to be revised in March, and we note that last year there was a positive revision for Puerto Rico. Meanwhile, the unemployment rate increased to 11.8% in the second half of 2006, though a portion of the increase was due to a moderate increase in the (historically very low) workforce participation rate on the island.” While the audited CAFR confirmed challenges for FY05, the PR Treasury Department disclosed monthly General Fund revenue figures, which should have alerted PR banks that despite the new FY06 taxes to reduce the deficit, revenue growth was instead increasingly relying on royalties from exempt companies. Data released by treasury in December 2008 on the distribution of revenues from tax exempt versus taxable corporations (See Appendix 5), confirmed that during FY06 tax revenues from taxable companies were
28 See $1,042,500,000 Commonwealth of Puerto Rico Tax Revenue Anticipation Notes Series 2006, December 22, 2005. 29 November 21, 2005 Joint Resolution 321. 30 February 2006: Special Comment, Moody’s Credit Update on Commonwealth of Puerto Rico, structural budget deficit still exceeds $1 billion, Commonwealth continues to debate fiscal and tax reforms, page 2.
31 Moody’s Investors Service, Special Comment, Moody’s Credit Update on Commonwealth of Puerto Rico, Structural budget deficit still exceeds $1 billion, Commonwealth continues to debate fiscal about tax reforms, February 2006, by Timothy Blake, Robert Kurtter. See Table 2 of their Special Comment. 32 Pfizer, one of Puerto Rico’s top exporters, tax payers and employers, announced a restructuring in January 2005.
33
down by-35%, a major risk indicator of shrinking margins, losses and overall drop in demand due to the economic slowdown.
Table 3
Source: Treasury Department
As a result of bubble, the General Fund faced an abrupt increase and subsequent contraction of approximately $450M in GF revenues from taxable corporations. See Graph 31. PR’s corporate structure is characterized by high concentration risks. There were merely 70-80 taxable companies with more than $50M in gross income during the CY2001-2008 period but they accounted for an average of 46% of the total tax liability (TTL) of corporate taxpayers. See Graph 32. Leading this segment includes banks, insurance companies, developers and large retailers, all benefiting from the real estate bubble and from lack of strong competition. Companies in this segment were major beneficiaries of the combined public and private bubble.
Within this group, TTL of Corporate taxpayers with >$50M in gross income increased by $400M from CY02 low point to CY 06 peak, or from 37% of TTL in FY02 and to 55% in CY06. The CY06-CY08 period, in contrast, led to a $376M reduction in the tax liability of this segment. Loss carry forwards from these corporations’ certainly affected public finances. Therefore, the bubble period increased the tax dependence risk of the central government in a small number of companies in this segment. This breakdown is publicly disclosed annually from PR Treasury.
2005 2006
GF Net Revenues from Internal Sources 7,938 8,185
All Corporate Taxes (GF) 1,891 1,872
All Corporate Taxes (GF) plus Tollgate Tax 1,914 1,899
Corporate Taxes from Taxable Companies 951 621
Corporate Taxes from Exempt Companies, all
below 963 1,278
Income Tax 527 505
Taxes on Royalties 413 746
Tollgate Taxes 23 27
Act 154 Taxes - -
Royalties as % of Total 43% 58%
Fiscal Years
34
Graph 31
Source: PR Treasury Department, Taxable Corporations Income Tax Returns Statistics, http://www.hacienda.gobierno.pr/estadisticas/datos_seleccionados.html
The bubble led to a surge in new small businesses, most in retail trade and services, all chasing the increase in income, government spending, and real estate equity extraction and bank credit concession. All of this activity was not sustainable. The data also confirms than small businesses started facing earnings reduction one year before those with sales above $50M. See Graph 32.
Graph 32
Source: PR Treasury Department, Taxable Corporations Income Tax Returns Statistics, http://www.hacienda.gobierno.pr/estadisticas/datos_seleccionados.html
785,743
1,199,460 1,255,723
799,279 750,000
850,000
950,000
1,050,000
1,150,000
1,250,000
1,350,000
2001 2002 2003 2004 2005 2006 2007 2008
ALL PR TAXABLE CORPORATIONS All Taxes Paid by Tax Years
(do not correspond to Fiscal Years and therefore General Fund Revenues)
Total Corporate TaxLiabilities
275,000
325,000
375,000
425,000
475,000
525,000
575,000
625,000
675,000
725,000
2001 2002 2003 2004 2005 2006 2007 2008
$ M
PR TAXABLE CORPORATIONS BY SEGMENTTax Years (do not correspond to Fiscal Years and therefore General Fund Revenues)
Total Tax liability fromCorp with >$50M inGross Income
Total Tax Liability fromCorp with <$50M inGross Income
35
May 2006 government shutdown. The two week shutdown left public employees without pay and was a profound historic shock to the payment’s system in an economy with highly leveraged households and businesses. Moody’s downgraded the central government GO rating to Baa2 in May and confirmed a negative outlook in July 2006.
On May 25, 2006 Fiscal Reform Act 103 was approved, seeking to establish new controls, procedures and assess the underlying financial information systems. However, new procedures were not adopted and the previous pattern continued:
1. Over-optimistic macroeconomic forecasts of the PR economy 2. Leading to unrealistic growth forecasts for General Fund tax revenues (revenues were $1.1BN below
forecast in FY06). 3. Consequently leading to over budgeting, allowing for increases in employment and payroll 4. Increased GDB loans and issuance of debt securities for deficit financing 5. And widening deficits confirmed by the CAFR
Upon reviewing year to date and closing FY General Fund estimates and economic indicators, on May and July 2006 Moody’s and S&P respectively downgraded the central government credit rating with a negative outlook; the third downgrade since FY02. S&P had issued a credit watch earlier in March 2006. See Graph 33.
Graph 33
Commonwealth of PR, General Obligation Rating Credit
Source: Moody’s, S&P, Lockwood Financial Advisors Corp.
FY06 General Fund deficit ended being $384M even after GDB granted loans to the Commonwealth for $741 million, respectively, to cover the Commonwealth’s budget deficit. In FY06 GF expenditures were 9.332M and revenues $8.306M. $1.4BN from non-recurrent transactions were completed to finance the deficit: besides the GDB loan of $741M repayable from the new sales tax; it included a refinancing and restructuring of the GO debt service for $368M, cash management controls in the amount of $150M; a basis swaps in the amount of $100M and the use of $64M in emergency funds. As of June 30, 2006, the
36
outstanding principal amount of GDB loans granted to finance the Commonwealth’s budget deficit was $1.8 billion or 25% of all loans and 87% of net assets.
The CAFR also confirmed a significant deterioration in the financial condition of public corporations, with negative net assets. See Graph 34. Leading the deterioration, during FY06 the Highways and Transportation Authority saw its net assets change from -$90M to -$576M due to losses from Tren Urbano, Bus Authority and Agua Guagua, despite increases in tolls and other Authority revenues in FY05. Weakening public corporation credit quality should raise concerns on their ability to invest, support existing and new housing connections and stimulate the economy
Graph 34
Source: Annual CAFRs
As we have discussed in the Investment section above, public investment financed thru debt issuance and GDB advances increased until FY06, but there was also higher reliance on Debt Issuance to fund Operating Expenses, reimburse GDB loans thru long term debt issuance (Act 164 of 2001) and restructure Debt Service. As a result of lax practices and poor selection of capital investment projects, total public sector debt increased by 75% from 2000 to 2006. See Graph 35.
(1,400,000)
(1,200,000)
(1,000,000)
(800,000)
(600,000)
(400,000)
(200,000)
-
200,000
400,000
2002 2003 2004 2005 2006
Changes in Net Assets Per Component Unit (Program Revenues) FY02 thru 06
Government Development Bank
Highways and TransportationAuthority
Electric Power Authority
Aqueduct and Sewer Authority
University of Puerto Rico
Health Insurance Administration
Nonmajor Component Units (includingIFA)
37
Graph 35
Source: Annual CAFRS and Government Development Bank for PR Report on PR Public Debt http://gdbpr.com/spa/publications-reports/public-debt.html
Puerto Rico Banking System Performance
At the start of 2006, the PR banking system was facing a sharp reduction in earnings for the second year in a row, driven by a slowdown in loan concession and deposits, increases in loss reserves and higher interest costs.33 2004 had registered peak stock prices and earnings of $1.5BN, when GNP growth rate was 2.7% and without an inverted yield curve.
Analysts34 alerted that net interest margin compression (NIM) would be higher and earnings weaker than expected starting Q3 at some of the banks due to the following three reasons:
1. “Inverted yield curve: The yield curve was inverted for most of the quarter, which is likely to have impacted asset yields on longer dated assets like mortgages.
2. Continued tough competition for assets: As most of the banks no longer relying on purchasing mortgages from the local mortgage originators, organic loan growth has become a priority, with some banks aggressively pricing loans to attract volume. This puts pressure on other players to also lower rates or risk losing business. We are concerned that this practice has resulted on loans not
33 Public sector debt refinancing savings were also ending as a result of rising interest rates. 34 See UBS Investment Research, Puerto Rican Banks, Still Too Early to Get Excited: 3Q06 Results Likely to Disappoint, 10 October 2006, authored by Omotayo Okusanya, II, CFA.
38
being priced adequately for risk, as it has become increasingly common for unsecured consumer loans and commercial loans to be priced below the prime rate.
3. Continued tough competition for deposits: competition for deposits also remains on the rise, with the local mortgage originators offering the most attractive rates as they try to shore up capital to run their businesses.”
PR banking system earnings for CY06 dropped to $375M, -67% less than the previous year. A positive scenario was developed by Moody’s in their August 2006 Banking System Outlook, stating that “there remains a housing shortage in Puerto Rico, particularly at the lower and middle parts of the market, which should keep demand for mortgages relatively robust even in the absence of significant refinancing activity…since Puerto Rican consumers typically refinance in order to consolidate their debts, as opposed to lowering their monthly payments, even refinancing activity will continue in a higher rate environment, albeit at a slower pace. These attributes suggest continued healthy levels of mortgage origination going forward.” But mortgage growth was moving in a different direction. See Graph 36. An August 2007 Banco Santander Puerto Rico presentation highlighted the sudden Sept 2005- Sept 2006 contraction in the volume of residential mortgage origination and deep real estate restructuring challenges ahead:
“Mortgage origination has contracted for the following reasons: a drop in the previous upward trend in real estate values, an increase in interest rates, plus a drop in underlying investment levels and employment creation. The backlog of unsold housing units may require between two to three years to be absorbed. Residential Mortgage origination begins to drop in Q3 05 but had been erratic during 03 and 04.” 35
Graph 36
Puerto Rico Banking System, Residential Mortgage Origination, Q1 03 thru Q2 07
Source: Banco Santander August 2007 Presentation to PR CPAs.
35 Page 15, Banco Santander Puerto Rico, Entorno Económico y Sistema Financiero, presentación ante Convención Anual Colegio de CPAs, 30 de agosto de 2007, Fajardo, Puerto Rico. Referred to in supporting documents as Banco Santander August 2007 Presentation to PR CPAs.
39
By the end of CY06 PR banking assets in non-accrual status increased by 104% compared to year end 2004, reaching $1.3BN and those in the 30-90 day PDNA segment by 96%, reaching $1.4BN. See Graph 37. CY06 total PR banking system net charge offs reached $314M, up 32% from the previous year, and total banking system net income was $652M or 30% less than CY05. By March 2006 PDNA Loans to individuals and other consumer loans had also worsened for 8 consecutive quarters.
Graph 37
Total Loans Past Due and Non-Accrual, PR Banking System Dec 2001-Dec 2006
Source: FDIC
Real estate PDNA gave clear indications of worsening as early as January-June 2005, at a time of major fiscal tension between Executive and Legislative branches on the disclosure of a FY05 $1.5BN deficit and the approval of the FY06 government budget. See Table 4 and Graph 38.
Table 4
Credit Quality, Real Estate Loans in Domestic Offices, PR Banking System, Dec 2004-Dec 2006
0
200,000
400,000
600,000
800,000
1,000,000
1,200,000
1,400,000
1,600,000
PDNA 30-90 PDNA 90+ ANacS
DATEReal estate loans in
domestic offices: 30-89 90+
Nonaccrual
statusTOTAL
PDNA (30-
89)
PDNA
(90+)
Nonaccrual
status
Dec. 2004 21,666,928 164,279 33,318 325,398 522,995 0.76% 0.15% 1.50%
Mar. 2005 29,383,798 306,452 84,925 401,453 792,830 1.04% 0.29% 1.37%
Jun. 2005 30,361,609 341,324 109,158 399,776 850,258 1.12% 0.36% 1.32%
Sep. 2005 32,446,499 351,559 96,167 450,871 898,597 1.08% 0.30% 1.39%
Dec. 2005 30,700,076 468,623 96,525 504,354 1,069,502 1.53% 0.31% 1.64%
Mar. 2006 32,279,088 531,116 94,202 510,798 1,136,116 1.65% 0.29% 1.58%
Jun. 2006 34,442,754 614,264 101,797 686,234 1,402,295 1.78% 0.30% 1.99%
Sep. 2006 34,738,217 733,340 114,574 770,607 1,618,521 2.11% 0.33% 2.22%
Dec. 2006 35,038,789 677,028 120,126 889,688 1,686,842 1.93% 0.34% 2.54%
40
From December 2004 to March 2006 PR banking system real estate loans in domestic offices in PDNA status had increased for 6 consecutive quarters, from $523M to $1.1BN or by 117% (See Table 4). $367M of this increase came from the 30-89 day segment (which increased 223% and required a full risk review given that it could be a leading indicator) but 90+ days had also increased by $61M or 183% and those in non-accrual had increased by $185 M or 57%.
Graph 38
The share of PDNA within secured 1-4 residential property loans increased dramatically from December 2004 to December 2006 from $314M to $1BN, accounting for 2.63% to 6.52% of all 1-4 residential property loans. Worsening conditions were evident in both 30-90 days and non-accrual segments. See Table 5.
0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
3.00%
PDNA: Real Estate Loans in domestic offices December 2004-December 2006
PDNA (30-89)
PDNA (90+)
Nonaccrual status
41
Table 5
Real Estate Loans Secured by 1-4 Family Residential Properties, 2006
However, it was precisely during this period that PR banks increased their exposure in construction and land development loans: from December 2004 to December 2006 their share of all real estate loans increased from 11% to 17%.
Table 6
Construction and Land Development Loans, 2006
As of year-end 2006, the share of all real estate loans within total net loans and leases for the PR banking system increased from 54% to 61%.
DATE
Secured by 1-4
family
residential
properties
30-89 90+Nonaccrual
statusTOTAL
PDNA (30-
89)
PDNA
(90+)
Nonaccrual
status
Dec. 2005 14,398,769 337,279 82,784 276,818 696,881 2.34% 0.57% 1.92%
Mar. 2006 14,366,989 343,604 93,291 300,668 737,563 2.39% 0.65% 2.09%
Jun. 2006 16,095,745 394,532 100,898 359,440 854,870 2.45% 0.63% 2.23%
Sep. 2006 15,835,971 463,423 104,041 389,727 957,191 2.93% 0.66% 2.46%
Dec. 2006 15,528,586 478,283 113,363 421,181 1,012,827 3.08% 0.73% 2.71%
Change
during
period
above
8% 42% 37% 52% 45%
DATE
Construction
and Land
Development
Loans
30-89 90+Nonaccrual
statusTOTAL
PDNA (30-
89)
PDNA
(90+)
Nonaccrual
status
Dec. 2005 4,880,002 41,313 12,240 48,937 102,490 0.85% 0.25% 1.00%
Mar. 2006 5,435,464 84,862 0 57,404 142,266 1.56% 0.00% 1.06%
Jun. 2006 5,602,807 86,673 0 68,187 154,860 1.55% 0.00% 1.22%
Sep. 2006 5,798,106 125,285 2,274 93,162 220,721 2.16% 0.04% 1.61%
Dec. 2006 6,077,088 57,387 0 151,192 208,579 0.94% 0.00% 2.49%
42
Graph 39
Distribution of Net Loans and Leases by Major Categories, PR Banking System
The PRSI continued to decline during 2006 and the rest of the period reviewed by this Report. See Graph 40.
Graph 40
Source: GDB
43
Credit Rating Agency’s 2006 Reports on Puerto Rico Banking System
August 2006 Moody’s Puerto Rican Banking System Outlook36 is "stable to negative and will continue to be defined by the banks' abilities to manage through the difficult operating environment." "More specifically," says Vice President Allen Tischler, the report's author, "of the five rated Puerto Rican banking companies, our outlook is stable for three (Popular and the two Spanish-owned banks, BBVA Puerto Rico and Banco Santander Puerto Rico) and negative for two (Doral and Firstbank)." He explains that "ratings of the first three institutions have not changed since the industry's challenges began to unfold because we believe their franchise strengths remain intact. The past year has been difficult for all Puerto Rican banks. In addition to internally generated conditions37," the analyst notes, "the local economy has undergone a budgetary crisis and considerable political indecision at the commonwealth government level -- a situation that has challenged both private and public sector employment." "Fortunately, most of the rated banks have minimal direct exposure to government debt," he adds. “The analyst believes that loan demand may keep softening as the impact of the local government budget crisis continues to be felt and as borrowing costs increase because of the upward re-pricing of loans -- both from the rise in interest rates and from more widespread use of risk-based pricing at local banks. "Moreover," Mr. Tischler says, "a general economic slowdown may have a long-term effect on asset quality," adding that local banks have already reported a significant softening of demand for some loan categories -- in particular, those for auto loans. Nonperforming statistics for the rated banks remain inferior to the US mainland peers' averages. At the bank level, the four (Doral's bank subsidiary is not rated) reported the measure of NPAs to tangible common equity plus loan loss reserves to have moved from 10.6% to 16.2% at December 31, 2005. This can be compared with the average for similarly sized mainland banks of about half those levels or less. "We want to point out that our current ratings assume a weakening of asset quality in the Puerto Rican banking system," the analyst says. He concludes that "negative rating pressure related to asset quality deterioration would only emerge in the event that asset quality deteriorated beyond our current expectations."
Bank Equity Analysts’ Reports during 2006
Analysts’ concerns with PR bank stocks still being 17-55% overvalued persisted, based on deteriorating credit quality and subpar loss reserves. As example, Firstbank’s loan loss reserve was found “too light, especially for the continued deterioration expected for the portfolio. As such, we calculate a loan loss reserve shortfall of at least $45.0 million. We simply do not understand why an organization that has just had a 24.1% increase in new problem loans, a 5.1% increase loans 30-89 days past due, and NCOs of $32.9 million refuses to increase its loan loss reserve to regulatory standards.”38
2006 Brookings Institution and Center for the New Economy Study on PR
Authors Maldonado-Bear and Walter present detailed summaries of each of the components of the financial sector.39 The authors find that growth in private sector loans—which arguably contribute most directly to economic development—has lagged behind growth in the sector as a whole. Furthermore, the banks have emphasized debt, rather than deposits, to finance their growth.
36 Moody’s stopped releasing its annual outlook on Puerto Rico banks during 2006. 37 “Problems with internal accounting issues at several local institutions ultimately led to financial accounting restatements, notable managerial changes, and heightened regulatory scrutiny at several banking entities, two of which are rated by Moody's -- Doral Financial and FirstBank Puerto Rico. The significance of these accounting issues was recognized by Moody's," Mr. Tischler states, "in the rating actions we took on the companies with the most noteworthy challenges (Doral and FirstBank), which were both subjected to significant downgrades." 38 Sterne Agee, First Bancorp, Company Report, Downgrading to Sell Based on Valuation, October 5, 2006, Thomas J. Monaco and Kyle O’Brien. 39Brookings Institution Press and Center for the New Economy, Restoring Growth in Puerto Rico Overview and Policy Options, August 2006, http://www.brookings.edu/research/books/2006/restoringgrowthinpuertorico
44
Maldonado-Bear and Walter also discuss the crucial role played by the GDB. The authors find that while the GDB performs many crucial services, it has in recent years become weakened by the growing government budget deficits. The government has borrowed substantial sums from the GDB to cover its operating expenses. The recent downgrading of the commonwealth’s bond status means the GDB’s high exposure to government debt carries significant risk. In addition, government borrowing from the GDB crowds out private sector borrowers. Perhaps most troubling, the comparatively low interest rates offered by the GDB encourage government deficits beyond what many feel are prudent levels. The authors argue that all the banks on the island is the need to invest less in securities and instead to lend for commercial and industrial purposes at longer maturities, because doing so is more conducive to economic development, even though it is less liquid and hence more risky. The trade-off between dedicating funds for development and for more liquid investments—securities issued mainly outside Puerto Rico—is a necessity if the banks are indeed going to do their job to stimulate development. In the long run this will prove a sound investment for the banks as the industrial and business sectors of the island develop and strengthen.
45
2007 RISKS
Summary of Key Findings
Staring at the end of 2007, the Financial Crisis led to an unprecedented shift in monetary policy and use of
the Federal Reserve balance sheet to reduce stress in financial markets. But the April 2007 GFSR had
already alerted that “U.S. residential mortgage-related securities represent one of the largest pools of
fixed-income securities in the world’ but given that credit risk is highly concentrated among subprime
borrowers—i.e., those borrowers with impaired or limited credit histories—it is important to study the U.S.
mortgage market, since it is one of the few markets where such borrowers represent a notable portion of
the overall market.” GFSR alerted that the weaker mortgage collateral was partly been associated with
adverse trends in employment and income in specific U.S. states rather than with particularly rapidly
rising housing markets. In addition, a prolonged period of high home price appreciation coincided with a
relaxation in underwriting standards, resulting in a rise in the proportions of less creditworthy borrowers,
more highly leveraged loans, and more risky mortgage structures.”
The GFSR also alerted that the risk of a possible disorderly unwinding of global imbalances, since low
interest rates and healthy corporate balance sheets had spurred an increase in private equity buyouts. This
has led to a substantial rise in leverage in the acquired firms, potentially making such firms more vulnerable
to economic shocks. The increased use of leveraged loans as part of financing also poses risks to some
intermediaries that provide bridge financing to leveraged-buyout transactions. The Report stated that
situation deserved careful attention, especially if a large high-profile deal were to run into difficulty, as this
could trigger a wider reappraisal of the risks involved.
In the meanwhile, the PR environment deteriorated markedly. Private Housing dropped abruptly by -27%
or $561M during F08, leading to drop in construction-related wholesale and retail trade, employment
and services. The halt was significant, given that during the previous FY07 it had dropped by merely -5%
or $116M.
During CY 2007 the Establishment Survey average monthly employment level was -20,440 compared to the
previous year. And one-third higher than the CY02 drop caused by the 2001 recession. Total establishment
Survey wages for CY07 registered another decline, with a mere growth of 2.3%. The first of two federal
minimum wage rates increases during the 2006-2008 period of analysis took place in July 2007.
Even with the special temporary tax on real estate, the surtax on banks and the beginning of sales tax
revenues, all of which reduced disposable incomes of households, Total Central Government Expenditures
were reduced to $9.2BN compared to $10BN in FY06. For the first time during the analysis period, taxable
corporations reduced their tax revenues to the General Fund, confirming the structural nature of the economic,
fiscal and financial system challenges. These were all major adverse events for total employment and bank
credit quality. Nevertheless the government started granting more than $200M in tax credits to assist in the
sale of housing units and bank real estate loans.
On May 22, 2007 S&P joined Moody’s and lowered its long-term rating on the Commonwealth of Puerto
Rico's GO debt one notch to 'BBB-' from 'BBB', reflecting a long history of structural imbalance and the
ongoing difficulties anticipated with further efforts to reduce the accrued deficit. Puerto Rico, the jurisdiction
with lowest income and highest public debt, was on the verge of being non-investment grade. The pressure
to downgrade the Puerto Rico government was persistent since the second half of 2007: “the rating outlook
for the Commonwealth remains negative at this time. Although the Commonwealth has enacted legislation on
several fronts to improve its finances, the actual results of those reforms are not yet known. The aggressive
plan to reduce spending in key areas is unprecedented and results of the efforts for fiscal 2007 are not yet
in. What could move the rating down?
1. Growth of the structural budget gap back to double digits as a percentage of annual revenue.
46
2. Prolonged and severe recession, resulting in declining revenues and deficit increases.”
Those were precisely the two developments taking place.
For the PR banking system, year-end 2007 performance data made evident that the credit quality
deterioration had magnified; $5.7BN of total loans were in past-due and non-accrual status, up 97%
from year-end 2006. From December 2006 to December 2007, real estate non-accrual loans increased
from $890M to $2.9BN. Therefore, real estate had clearly become the worst performing segment, with
$2.05BN or 89% of the increase in total banking system non-accrual loans coming from real estate non-
accruals.
By year end 2007, secured by 1-4 family residential properties in non-accrual status increased by 89%.
CY07 also brought a sharp deterioration in the credit quality of $1.1 BN in construction and land
development loans: from December 2006 to December 2007 the percentage of loans in this segment
within the PDNA 30-89 category increased from 0.94% to 3% (reaching $205M), the 90+ category
increased from 0% to 0.18% (reaching $13M) and those in non-accrual status from 2.49% to 13.42% or
$918M.
During CY07 the PR banking system drastically increased its net charge-offs to $581M, an increase of
$267M or 85% over CY06. See Graph 8.
Global Financial Stability
The Financial Crisis led to an unprecedented shift in monetary policy and use of the Federal Reserve balance sheet. Since 2007 the Federal Reserve has introduced a number of programs to reduce stress in financial markets. Since December 2007, these Fed programs assist depository institutions facing difficulty raising funds in private markets, and credit markets outside the banking system stressed by extreme investor uncertainty regarding future economic conditions.
These programs have greatly increased the amount of assets held by the Federal Reserve—and, in turn, the monetary base. The assets in these nontraditional programs have been paid for with deposits at the Federal Reserve. Paying for purchased assets with deposits at the Fed causes increases in the monetary base dollar-for-dollar.
“Quantitative easing” refers to a monetary policy of increasing the growth of a monetary aggregate. Some economists, including some Federal Reserve economists and policymakers, advocate using open market purchases of U.S. Treasury securities to systematically increase the size of the monetary base. The Fed has continued to purchase Treasury and other securities since the intended fed funds rate was cut to zero. Such purchases increase the size of the Fed’s balance sheet and thus the monetary base.
2007 Global Financial Stability Report The April 2007 GFSR examined the possible spillovers from a deterioration in credit quality in the U.S. subprime mortgage market that had been identified in the 2006 GFSR, and identified several short-term risks.
First, the subprime segment of the U.S. housing market is showing signs of credit quality deterioration. While the fallout to date has been limited, there is scope for it to deepen and spread to other markets, possibly to structured mortgage credit products held by a variety of global investors. Fortunately, the economic impact of the housing market slowdown has been limited and some market indicators have begun to stabilize, suggesting that the financial effects may also be contained.
Second, low interest rates and healthy corporate balance sheets have spurred an increase in private equity buyouts. This has led to a substantial rise in leverage in the acquired firms, potentially making such firms more vulnerable to economic shocks. The increased use of leveraged
47
loans as part of financing also poses risks to some intermediaries that provide bridge financing to leveraged-buyout transactions. The situation bears careful attention, especially if a large high-profile deal runs into difficulty, as this could trigger a wider reappraisal of the risks involved.
Third, capital inflows to some emerging markets have risen rapidly, in part reflecting improved economic fundamentals, but also reflecting the search for yield given low interest rates in most mature markets. In general, strong private capital inflows are to be welcomed, as they reflect a reallocation of capital to more productive investments. However, the shift to private sector debt flows, especially bank-based flows into emerging Europe and portfolio flows into other regions, including sub-Saharan Africa, shows that foreign investors are taking more risk and an abrupt reversal cannot be ruled out.
Finally, while the downside risk from a possible disorderly unwinding of global imbalances has receded somewhat, it remains a concern. The larger role of fixed-income inflows in financing the U.S. current account deficit indicates that inflows into U.S. bond markets may have become more sensitive to changes in world interest rate differentials. (page ix)
The GFSR emphasized that the U.S. mortgage market deserved watching, not only because of the high number of foreigners holding these securities, but because there are not many markets in which less creditworthy borrowers are such a big part of the market: “U.S. residential mortgage-related securities represent one of the largest pools of fixed-income securities in the world, totaling around $5.8 trillion as of January 2007. Non-U.S. holdings of these securities, estimated at $850 billion as of mid-2006, represent a significant portion of foreign holdings of U.S. securities. Because credit risk is highly concentrated among subprime borrowers—i.e., those borrowers with impaired or limited credit histories—it is important to study the U.S. mortgage market, since it is one of the few markets where such borrowers represent a notable portion of the overall market.” (Citations omitted). (Page 4) The delinquencies of the most recent subprime mortgages was increasing, which they related to rising unemployment and higher leveraged loans: “[M]any market participants expect subprime delinquency rates to eventually surpass previous peaks. Indeed, growth rates of subprime delinquencies for recent mortgage vintages, notably 2006, are on steeper trajectories than the previously steepest vintage of 2000. This deterioration reflects a combination of regional economic factors and a shift in the structure of the U.S. mortgage market over the last few years. Specifically, the weaker mortgage collateral has partly been associated with adverse trends in employment and income in specific U.S. states rather than with particularly rapidly rising housing markets. In addition, a prolonged period of high home price appreciation coincided with a relaxation in underwriting standards, resulting in a rise in the proportions of less creditworthy borrowers, more highly leveraged loans, and more risky mortgage structures.” (Citations omitted). (Page 5) The GFSR warned that the market structures of the securities collateralized by subprime mortgages was so complex, there was no clear how risks were allocated. “While the weakening U.S. housing market has had a limited effect on the overall financial system, the U.S. subprime segment is showing credit quality strains. So far, this has not affected financial stability overall, but because the complex market structures of mortgage-related securities can disguise how risks are allocated, who holds them, and the degree to which they are hedged, financial supervisors need to identify the potential for spillovers. In this regard, ensuring that underwriting standards are maintained is critical to supporting market discipline and, in this regard, recently issued guidelines are welcome.” (Page 32) The October 2007 GFSR increased the tone of its warning: “credit and market risks have risen and markets have become more volatile. Markets are recognizing the extent to which credit discipline has deteriorated in recent years—most notably in the U.S. nonprime mortgage and leveraged loan markets, but also in other related credit markets. This has prompted a retrenchment from some risky assets and deleveraging, causing a widening of credit spreads in riskier asset classes and more volatile bond and equity markets. The absence of prices and secondary markets for some structured credit products, and concerns about the location and size of potential losses, has led to disruptions in some money markets and
48
funding difficulties for a number of financial institutions, as some counterparties have been reluctant to extend credit to those thought to hold lower quality, illiquid assets. The resulting disruption has required extraordinary liquidity injections by a number of central banks to facilitate the orderly functioning of these markets. The potential consequences of this episode should not be underestimated…” (Page ix) “The threat to financial stability increased as the uncertainty became manifest in the money markets that provide short-term financing (especially commercial paper markets). At the center of the turmoil is a funding mismatch whereby medium-term, illiquid, and hard-to-value assets, such as structured credit securities, were being funded by very short-term money market securities—often asset-backed commercial paper. The market illiquidity and the difficulty in valuing the complex, structured products held as assets has compounded the risks of the funding mismatch. Thus, while potentially helping protect the financial system from concentrations of credit risk in banks, the dispersal of structured credit products has substantially increased uncertainty about the extent of the risks and where they are ultimately held.” (Page ix) The warning given in the April 2007 GFSR of not knowing where the risks of these securities with such complex structures allocated, who holds them, and the degree to which they are hedged had affected financial institutions access to liquidity: “The uncertainty about where off-balance-sheet bank exposures will materialize next has led to a tiering of interbank lending rates. Banks that are believed to either have structured credit product losses, or that need to satisfy contingent credit lines to their conduits or special purpose vehicles, face higher interbank rates. In some cases, the flows in the interbank market are stymied by some large banks’ desire to hold onto liquidity in case they need to finance other activities, such as the large pipeline of leveraged buyouts scheduled for the remainder of the year. Overall, there has been a sharp rise in perceived counterparty risk, and a desire to keep the additional liquidity on hand, at least for now.” (Page x) “Financial institutions holding such securities [complex products in the context of a market where liquidity is insufficient to provide reliable market prices] as collateral will need to assign a “haircut” that factors in liquidity characteristics. Importantly, financial institutions need to make sure that they have robust funding strategies appropriately suited for their business model and that such funding strategies can accommodate stressful conditions.” (Page xii) “The April 2007 GFSR highlighted rising credit risk in U.S. mortgage-related instruments, a loosening of credit standards across a range of markets, and risks of spillovers to other credit markets. Since then, these credit risks have materialized and intensified, with ratings agencies downgrading significant amounts of mortgage-related securities, and spreads on mortgage-related securities widening. These risks have been exacerbated by signs of similar credit indiscipline in the leveraged buyout (LBO) sector. Through mid-2007, there had been a marked rise in covenant-lite loans, less creditworthy deals, leverage, and price multiples on acquisitions. Moreover, now that ratings agencies are revising their model assumptions for structured products collateralized by mortgages, uncertainty has risen about the ratings of the broader structured credit market, including collateralized loan obligations (CLOs) that distribute leveraged loan financing to institutions. Reflecting the broader repricing of credit risk, spreads on high-yield corporate debt have widened from the tight levels reached earlier in the year.” (Citations omitted) (Page 2) “The widening in interest rate swaps and credit default swaps (CDS) referencing some investment banks illustrates market concerns of deeper stress for financial institutions. While potential losses appear to be manageable and banks appear well capitalized to weather more severe stress, there is at present considerable uncertainty regarding the magnitude and distribution of losses stemming from the correction in credit markets…” (Page 3) “Tighter monetary and credit conditions could reduce economic activity through a few channels. First, a tightening of the supply of credit to weaker household borrowers could exacerbate the downturn in the
49
U.S. housing market. Second, falling equity prices could reduce spending through the wealth effect and a weakening of consumer sentiment. Third, capital spending could be curtailed owing to a higher cost of capital for the corporate sector. Last, and perhaps most importantly, the dislocations in credit and funding markets during the period of market turbulence could restrict the overall provision and channeling of credit. The chances of a more severe tightening of credit conditions cannot be dismissed.” (Page 5)
Investment and Construction Indicators
Private Housing dropped abruptly by -27% or $561M during F08, leading to drop in construction-related wholesale and retail trade, employment and services. The halt was significant, given that during the previous FY07 it had dropped by merely -5% or $116M. See Graph 41.
Graph 41
Source: PR Planning Board GDFI Table 8 Statistical Appendix
As discussed in 2006, new housing units authorized by the PR Planning Board registered a slight contraction while the average price of units authorized continued to increase. See Graphs 42 and 43. The disconnect between developers and market economic conditions continued to worsen.
2,872.5
2,704.1
2,471.4
2,703.8
2,062.9 2,217.7
2,101.9
1,540.9 1,578.2
1,106.6
1,176.8
1,145.8
500.0
1,000.0
1,500.0
2,000.0
2,500.0
3,000.0
3,500.0
2003 2004 2005 2006 2007 2008r
$ C
urr
ent
Construction Segments. FY 03 thru 08Gross Fixed Domestic Investment
Public Total
Private Housing
Private Industrial andCommercial
50
Graph 42
Graph 43
Employment, Wages and Disposable Income
During CY 2007 the Establishment Survey average monthly employment level was -20,440 compared to the previous year. See Table 7 and Graph 44. This reduction was one-third higher than the CY02 drop caused by the 2001 recession. State government employment accounted for 37% of the reduction in total employment during CY07, followed by manufacturing with 21%, though less than in CY06. For these reasons we have been stressing the importance of manufacturing contraction and public finance instability with household finances and their ability to meet their credit obligations and/or acquire new properties, particularly when real estate collaterals values were decreasing.
-1500
-1000
-500
0
500
1000
Jan Feb March Apr May Jun Jul Aug Sept Oct Nov Dec
New Housing Units Authorized, Monthly 2006-2007
2006 2007 Linear (2006) Linear (2007)
55
6161
71
73
50
55
60
65
70
75
2003 2004 2005 2006 2007
Average Private Housing Unit Value
51
The key underlying event during CY07 was a reduction in central government, which declined by 6% or 7,661 from the previous year, but all segments faced employment losses.
Table 7
]
Monthly data series in Graph 45 confirm that 2007 employment levels were down on average 2% every single month compared to the previous year. This level of -2% month over month reductions had started in August 2006.
Graph 44
Total Manufacturing Construction Services State Govt Other
2006 (11,202) (5,106) (3,186) 2,167 (2,198) -2879
2007 (20,440) (4,326) (2,858) (3,119) (7,661) -2476
Source: US Dept. of Labor, Bureau Labor Statistics, QCEW
Change in Employment, Establishment Survey
1,048,004
1,036,802
1,016,362
990,000
1,000,000
1,010,000
1,020,000
1,030,000
1,040,000
1,050,000
1,060,000
2005 2006 2007
Puerto Rico, Average Annual Establishment Employment CY 05-07
52
Graph 45
Wages. Total establishment Survey wages for CY07 registered another decline, with a mere growth of 2.3%. See Graph 46. The first of two federal minimum wage rates increases during the 2006-2008 period of analysis took place in July 2007. The previous rate of $5.15 had been adopted in September 1, 1997.
Jul 24, 2007 $5.85 for all covered, nonexempt workers
Jul 24, 2008 $6.55 for all covered, nonexempt workers
Graph 46
Source: US Department of Labor, Bureau of Labor Statistics, Quarterly Census of Employment and Wages
980000
1000000
1020000
1040000
1060000
1080000
1100000
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Puerto Rico Monthly Establishment Employment 2005-2007
2005
2006
2007
3.1%
2.6%
2.3%
2.0%
2.2%
2.4%
2.6%
2.8%
3.0%
3.2%
2005 2006 2007
Total Wages All Industries Puerto Rico
Annual CY % Change 2005-2007
53
Public Financial Management
The FY06 CAFR was released in August 6, 2007 and confirmed a deterioration and instability in central government public finances affecting overall economic, fiscal and financial system conditions, including real estate and banking system credit quality. The following were the most important developments:
1. The central government General Fund deficit had grown to $511M in FY0, but decreased to $384M in FY06. This was the first improvement since FY02, led by $473M in new revenues from newly adopted taxes while expenditures decreased by $469M. However, $163M of this reduction was in capital investment, further affecting construction activity.
2. The broader Governmental Funds Balance slightly improved, with a FY06 closing balance of $411M compared to $386M during the previous year.
The PR Treasury Department released FY07 General Fund monthly revenues, which led to an increase in total revenues from internal sources, supported by the extension of special temporary tax on real estate, the surtax on banks and the beginning of sales tax revenues. All of these new taxes reduced disposable income. The central government took a $180M loan from the State Insurance Fund. Total Central Government Expenditures were reduced to $9.2BN compared to $10BN in FY06. This was a major adverse event for total employment and bank credit quality.
Table 8
Tax Credits claimed increased significantly starting in FY07. See Graph 47. 2007 was characterized by a rise in claims of Puerto Rico tax credits fueling real estate investment and lending, without the government assessing their effectiveness and fiscal impact. Multiple tax credit programs were approved without assessing their fiscal impact, effectiveness and potential distortion of private investment decisions by corporate groups and banks. They sought to compensate for the lack of policy measures to gain competitiveness by reducing operational costs and making the academic system relevant to industry. By 2008 tax credit claims had increased six-fold to almost $600M. The main reasons behind this increase were two-fold: a $220M tax credit adopted in 2007 to stimulate new housing unit sales; in addition, the 2008 Tax Incentives Act for multinational investment allowed companies to claim newly designed tax credits without converting to the new Act. These were both extremely large subsidies given the overall public financial deterioration.
2005 2006 2007
GF Net Revenues from Internal Sources 7,938 8,185 8,470
All Corporate Taxes (GF) 1,891 1,872 2,003
All Corporate Taxes (GF) plus Tollgate Tax 1,914 1,899 2,028
Corporate Taxes from Taxable Companies 951 621 713
Corporate Taxes from Exempt Companies, all
below 963 1,278 1,315
Income Tax 527 505 549
Taxes on Royalties 413 746 741
Tollgate Taxes 23 27 25
Act 154 Taxes - - -
Royalties as % of Total 43% 58% 56%
Fiscal Years
54
Graph 47
Credit Rating Reports Public Sector
On May 22, 2007 S&P lowered its long-term rating on the Commonwealth of Puerto Rico's GO debt one notch to 'BBB-' from 'BBB', reflecting “a long history of structural imbalance and the ongoing difficulties anticipated with further efforts to reduce the accrued deficit.40 The outlook was deemed stable. The rating on the appropriation debt, typically rated one notch below the GO, was lowered, “reflecting the improvements that have been made”.
a. The 'BBB/A-2' counterparty credit rating of Government Development Bank of Puerto Rico
(GDB Puerto Rico) has been lowered to 'BBB-/A-3’.
b. UPR system revenue bonds were lowered to 'BBB-' from 'BBB', with a stable outlook.
c. The downgrade reflects the lower rating on the Commonwealth's GO debt and UPR's high and increasing dependence upon the Commonwealth for its revenues. Under Commonwealth Act 2 of 1966, UPR is allocated an amount equal to 9.6% of the average total revenue collected by
40 See Standard and Poor’s, Ratings Direct, Research, Puerto Rico’s GO Debt Rating Lowered To ‘BBB-‘ Due to Structural Imbalance, 22 May 2007, Horacio Aldrete-Sanchez.
55
the Commonwealth Rico during the prior two fiscal years. Appropriations account for about 90% of UPR's operating budget and in fiscal 2006 appropriations from the Commonwealth were $835 million, or nearly $13,000 per student.
d. The ratings for the Puerto Rico Ports Authority (A-/Stable) and Puerto Rico Highways and
Transportation Authority's highway revenue bonds (A-/Stable), transportation revenue bonds (BBB+/Stable), subordinate transportation revenue bonds (BBB/Stable), and special facility revenue refunding bonds, 2003 series A, (BBB-/Stable) did not change, despite the lowering of the Commonwealth's rating. Standard & Poor's considered pledged revenues for these credits as fairly insulated. It stated, however, that “further deterioration in the Commonwealth's credit quality could be a rating concern for these transportation credits.”
Puerto Rico Banking System Performance
By year-end 2007, it was markedly evident that the credit quality deterioration had magnified; $5.7BN of total loans were in past-due and non-accrual status, up 97% from year-end 2006. See Graph 48. The surge was due to a $2.3B or 177% increase in non-accrual status loans.
Graph 48
Total Loans Past Due and Non-Accrual, PR Banking System Dec 2004-Dec 2007
From December 2006 to December 2007, real estate non-accrual loans increased from $890M to $2.9BN. Therefore, real estate had clearly become the worst performing segment, with $2.05BN or 89% of the increase in total banking system non-accrual loans coming from real estate non-accruals. See Table 9. Nevertheless, total real estate loans in domestic offices increased by $4BN or 12% during CY07, reaching $39BN. Within this total, construction and land development net loans and leases increased by $762M or 13% during CY07. To support further extension of credit to real estate loans given the fact that they were driving total banking system non-accruals is one of the core concerns of our Report.
1,320,107
3,661,247
0
500,000
1,000,000
1,500,000
2,000,000
2,500,000
3,000,000
3,500,000
4,000,000
PDNA 30-90 PDNA 90+ ANacS
56
Table 9
Credit Quality, Real Estate Loans in Domestic Offices, PR Banking System, Dec 2006-Dec 2007
Graph 49
During CY07 Real Estate Loans secured by 1-4 family residential properties increased by 10%, reaching
$17BN by year-end. However, total loans in PDNA increased by 52%. This growth was led by an 89%
increase in those in non-accrual status.
DATEReal estate loans in
domestic offices: 30-89 90+
Nonaccrual
statusTOTAL
PDNA (30-
89)
PDNA
(90+)
Nonaccrual
status
Dec. 2006 35,038,789 677,028 120,126 889,688 1,686,842 1.93% 0.34% 2.54%
Mar. 2007 35,764,741 696,857 130,891 1,031,592 1,859,340 1.95% 0.37% 2.88%
Jun. 2007 36,766,708 836,162 123,461 1,393,490 2,353,113 2.27% 0.34% 3.79%
Sep. 2007 37,725,244 1,009,518 144,183 1,912,263 3,065,964 2.68% 0.38% 5.07%
Dec. 2007 39,073,699 1,026,278 166,357 2,935,575 4,128,210 2.63% 0.43% 7.51%
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
8.00%
PDNA (30-89)
PDNA (90+)
Nonaccrual status
PDNA: Real estate Loans in domestic offices
December 2005-December 2007
57
Table 10
Real Estate Loans Secured by 1-4 Family Residential Properties, 2007
CY07 also brought a sharp deterioration in the credit quality of $1.1 BN in construction and land
development loans: from December 2006 to December 2007 the percentage of loans in this segment
within the PDNA 30-89 category increased from 0.94% to 3% (reaching $205M), the 90+ category
increased from 0% to 0.18% (reaching $13M) and those in non-accrual status from 2.49% to 13.42% or
$918M. See Table 11.
Table 11
Construction and Land Development Loans, 2007
As of year-end 2007, the share of all real estate loans within total net loans and leases for the PR banking system increased from 61% to 68%.
DATE
Secured by 1-4
family
residential
properties
30-89 90+Nonaccrual
statusTOTAL
PDNA (30-
89)
PDNA
(90+)
Nonaccrual
status
Dec. 2006 15,528,586 478,283 113,363 421,181 1,012,827 3.08% 0.73% 2.71%
Mar. 2007 15,881,593 496,184 117,793 489,965 1,103,942 3.12% 0.74% 3.09%
Jun. 2007 16,284,642 555,113 121,148 555,362 1,231,623 3.41% 0.74% 3.41%
Sep. 2007 16,646,928 596,060 138,188 737,870 1,472,118 3.58% 0.83% 4.43%
Dec. 2007 17,060,734 597,264 144,689 795,944 1,537,897 3.50% 0.85% 4.67%
Change
during
period
above
10% 25% 28% 89% 52%
DATE
Construction
and Land
Development
Loans
30-89 90+Nonaccrual
statusTOTAL
PDNA (30-
89)
PDNA
(90+)
Nonaccrual
status
Dec. 2006 6,077,088 57,387 0 151,192 208,579 0.94% 0.00% 2.49%
Mar. 2007 6,104,847 23,693 9,367 195,578 228,638 0.39% 0.15% 3.20%
Jun. 2007 6,319,473 75,482 709 226,988 303,179 1.19% 0.01% 3.59%
Sep. 2007 6,533,009 101,058 1,125 397,876 500,059 1.55% 0.02% 6.09%
Dec. 2007 6,838,882 205,462 12,571 917,524 1,135,557 3.00% 0.18% 13.42%
58
Graph 50
Distribution of Net Loans and Leases by Major Categories, PR Banking System
2008 RISKS
Summary of Key Findings
A deeper understanding and discussion of the long-term, structural consequences of the Global Financial Crisis characterized global financial affairs during 2008. Reduced capital buffers and uncertainty about the size and distribution of bank losses in the US and European Union, combined with normal credit cycle dynamics, were understood likely to weigh heavily on household borrowing, business investment, and asset prices, in turn feeding back onto employment, output growth, and balance sheets, with the potential of it being more severe than in previous credit cycles, given the degree of securitization and leverage in the financial system. Thus, the 2007-2008 turmoil was understood to be more than simply a liquidity event, reflecting deep-seated balance sheet fragilities and weak capital bases, which means its effects are likely to be broader, deeper, and more protracted.
Furthermore, the deleveraging in the banking sector will take place along multiple dimensions: requiring asset sales, slower new asset growth, and radical changes to banks’ business models as many previous sources of revenue have nearly disappeared.
While confirming concerns with the overall level of leverage and need for improved regulation, the GFSR highlighted that falling U.S. housing prices and rising delinquencies on mortgage payments could lead to aggregate losses related to the residential mortgage market and related securities of about $565 billion, including the expected deterioration of prime loans. Adding other categories of loans originated and securities issued in the United States related to commercial real estate, the consumer credit market, and corporations increases aggregate potential losses to about $945 billion. These estimates, while based on imprecise information about exposures and valuation, suggest potential added stress on bank capital and further write-downs. Moreover, combined with losses to nonbank financial institutions, including monocline bond insurers, the danger is that there may be additional reverberations back to the banking system as the deleveraging continues.
59
Puerto Rico was to face financial system deleveraging in a no growth environment, fraught with structural challenges and risks. During CY 2008, total banking system net credit concession was halted, focusing on loss reserves and real estate work outs.
Puerto Rico GDFI Construction Investment data up to FY09 (July 2008 thru June 2009) allows us to confirm the abrupt halt in Private Housing, as well as by Public Investment and Private Industrial and Commercial investment. With a span of only three years Private Housing investment had been reduced by half.
The reduction in Total Establishment employment during CY08 reached -15,242 jobs, and was led by Services contraction, closely followed by manufacturing and construction losses.
General Fund and Governmental Fund balances worsened during FY07 audited figures released in June 2008, even with $137M from the first year with sales tax revenues; a $180M loan from the State Insurance Fund, reduced healthcare expenditures by $107M and COFINA bond issue proceeds covering PFC debt service in the amount of $522M and allowing for a GO debt refinancing.
General Fund revenues from internal sources for FY08 were down sharply or by $-473M, as a result of overall worsening conditions. As a result the central government deficit remained at around $1BN, despite all the new taxes adopted.
During CY08 the PR banking system drastically increased its net charge-offs to $923M, an increase of $342M or 59% over CY07. As a result of its exposure to real estate and halt in net credit concession to the economy, the PR banking system became another drag on the economy.
By year-end 2008, $8.2BN of loans were in past-due and non-accrual status compared to $5.7BN in year-end 2007, up 44%. However, in contrast to 2007, this year the surge though led by non-accrual increases of $1.3BN, it also came from the PDNA 30-90 ($773M increase) and PDNA 90+ ($453M increase) categories, indicating a broadly worsening scenario.
Assisted by the Federal Reserve intervention programs, which stabilized US markets, in CY08 PR banks sold and securitized 1-4 family mortgages in the amount of $9.7BN, a peak year, compared to $6.5BN in 2007 and $5.5BN in 2006. Had it not been for such liquidity events, the overall environment would have worsened.
Total Real Estate Loans secured by 1-4 Family Residential Properties reached $18.4BN by December 2008. But those in PDNA increased by 48% from December 2007 to December 2008 (Table 15), reaching $2.3BN. In CY05, CY06 and CY07 it had also increased by 122%, 45% and 52%, respectively.
The CY07 increase was also led by the non-accrual segment which increased by 58% to reach 1.3BN, making 7% of all Real Estate Loans secured by 1-4 Family Residential Properties reach non-accrual status by December 2008, compared to 2%, 3% and 5% in December of 2005, 2006 and 2007, respectively.
During CY08, Construction and Land Development loans accounted for 16-17% of all real estate Loans in domestic offices, but those in 90+ and non-accrual status increased dramatically leading to a total of $2.3M in PDNA or 34% of this segment’s total as of December 2008.
In October 2008 Popular placed $175M in floating rate notes due 2011 with the GDB and EDB, out of a total of $250M. Finally in December 2008 and January 2009, Popular and Firstbank participated in the US Treasury Capital Purchase Program with $935M and $400M in preferred stock issuance, respectively.
Global Financial Stability
As we commented in our review of the 2007 GFSR, the concern with overall pervasive leverage was real and it was once again brought to the attention of the global financial community by the IMF during 2008: “While events [of the financial crisis] are still unfolding, the April 2008 GFSR assesses the vulnerabilities that the system is facing and offers tentative conclusions and policy lessons. Some key themes that emerge from this analysis include:
60
There was a collective failure to appreciate the extent of leverage taken on by a wide range of institutions—banks, monoline insurers, government-sponsored entities, hedge funds—and the associated risks of a disorderly unwinding.
Private sector risk management, disclosure, financial sector supervision, and regulation all lagged behind the rapid innovation and shifts in business models, leaving scope for excessive risk-taking, weak underwriting, maturity mismatches, and asset price inflation.
The transfer of risks off bank balance sheets was overestimated. As risks have materialized, this has placed enormous pressures back on the balance sheets of banks.
Notwithstanding unprecedented intervention by major central banks, financial markets remain under considerable strain, now compounded by a more worrisome macroeconomic environment, weakly capitalized institutions, and broad-based deleveraging. (page ix)
“[T]he crisis is spreading beyond the U.S. subprime market—namely to the prime residential and commercial real estate markets, consumer credit, and the low- to high-grade corporate credit markets. The United States remains the epicenter, as the U.S. subprime market was the origin of weakened credit standards and was the first to experience the complications arising from the associated structured credit products. But financial institutions in other countries have also been affected, reflecting the same overly benign global financial conditions and —to varying degrees —weaknesses in risk management systems and prudential supervision. Industrialized countries with inflated house price levels relative to fundamentals or stretched corporate or household balance sheets are also at risk.” (Page ix) “[The GFSR] projects that falling U.S. housing prices and rising delinquencies on mortgage payments could lead to aggregate losses related to the residential mortgage market and related securities of about $565 billion, including the expected deterioration of prime loans. Adding other categories of loans originated and securities issued in the United States related to commercial real estate, the consumer credit market, and corporations increases aggregate potential losses to about $945 billion. These estimates, while based on imprecise information about exposures and valuation, suggest potential added stress on bank capital and further write-downs. Moreover, combined with losses to nonbank financial institutions, including monocline bond insurers, the danger is that there may be additional reverberations back to the banking system as the deleveraging continues. The risk of litigation over contract performance is also growing.” “Macroeconomic feedback effects are also a growing concern. Reduced capital buffers and uncertainty about the size and distribution of bank losses, combined with normal credit cycle dynamics, are likely to weigh heavily on household borrowing, business investment, and asset prices, in turn feeding back onto employment, output growth, and balance sheets. This dynamic has the potential to be more severe than in previous credit cycles, given the degree of securitization and leverage in the financial system. Thus, it is now clear that the current turmoil is more than simply a liquidity event, reflecting deep-seated balance sheet fragilities and weak capital bases, which means its effects are likely to be broader, deeper, and more protracted.” (Page x) Among the actions suggested by the GFSR are:
Disclosure. Providing timely and consistent reporting of exposures and valuation methods to the public, particularly for structured credit products and other illiquid assets, will help alleviate uncertainties about regulated financial institutions’ positions.
Bank balance sheet repair. Write-downs, undertaken as soon as reasonable estimates of their size can be established, will help cleanse banks’ balance sheets. Weakly capitalized institutions should immediately seek to raise fresh equity and medium-term funding even if the cost of doing so appears high.
Overall risk management. Institutions could usefully disclose broad strategies that aim to correct the risk management failings that may have contributed to losses and liquidity difficulties. Governance structures and the integration of the management of different types of risk across the institution need to be improved. Counterparty risk management has also resurfaced as an issue to address. A re-examination of the progress made over the last decade and gaps that are
61
still present (perhaps inadequate information or risk management structures) will need to be closed.
Managerial compensation structures. Incentives that may act to shorten the horizon of top management of deposit-taking financial institutions need corrective action. Ideally, compensation at such regulated financial institutions should provide incentives to correct risk management failings early, provide for adequate capital and liquidity buffers, and generally take decisions that enhance the long-run viability of the firm so as to lessen systemic risks.
Early action to resolve troubled institutions. The public sector should proactively stand ready to promptly address stress within troubled financial institutions. In such cases, early remedial action or intervention may be warranted. (page xii-xiii)
The October 2008 GFSR stated that “The most significant risk remains the intensification of the adverse feedback loop between the financial system and the real economy.” (Page xiii) “Financial institutions had been raising capital to bolster their balance sheets and these efforts were initially successful, but now the prospects for further issuance are more limited and more expensive, reflecting weaker confidence in the underlying viability of institutions. As a result, [this report] suggests that the deleveraging in the banking sector will take place along multiple dimensions: requiring asset sales, slower new asset growth, and radical changes to banks’ business models as many previous sources of revenue have nearly disappeared.” (Page xiii) Among the key elements that financial institutions should implement to improve deficiencies to place financial intermediation on a more sound footing, some of which had been recommended in prior GFSRs:
Maintain an orderly deleveraging process. Financial institutions should, first, focus on strengthening their balance sheets—preferably by attracting new capital rather than selling assets; and second, ensure adequate funding sources consistent with their business model.
Strengthen risk management systems. As part of overall risk management improvements, firms should endeavor to better align compensation packages to reward returns on a risk-adjusted basis using more robust risk management practices, with greater emphasis on the long-term component of compensation.
Improve valuation techniques and reporting. Implementation of new Financial Stability Forum (FSF) disclosure guidelines and frequent asset valuations and timely disclosures will reduce uncertainty and are important steps that can help provide information about the health of counterparties.” (page xiv)
“[M]onetary policy transmission has been affected by the crisis, in light of three longer-term trends: increased growth of activity in near-banks, more extensive use of wholesale funding markets, and a movement away from a stable deposit base to a larger proportion of funding obtained with short-term maturities. Although these trends have generally made interest rate transmission more stable, over the last year the smooth relationships between the policy rate and lending rates that had been established changed dramatically, particularly for the United States. From mid-2007 until June 2008, the reliability of forecasting lending rates for both the United States and for the euro area has deteriorated, but more so for the United States.” (Page xv)
Investment and Construction Indicators
GDFI Construction Investment data up to FY09 (July 2008 thru June 2009) allows us to confirm the abrupt halt in Private Housing, as well as by Public Investment and Private Industrial and Commercial investment. With a span of only three years Private Housing investment had been reduced by half. See Graph 51.
As we will review further ahead, public sector investment capacity was constrained given fiscal deterioration and lack of additional GDB liquidity to provide interim financing to the central government and public corporations.
62
Graph 51
Source: PR Planning Board GDFI Table 8 Statistical Appendix
Newly authorized new housing units declined during 2008, as well as the average value price of such units.
Graph 52
Graph 53
2,872.5
2,704.1
2,471.4
2,703.8
2,332.9 2,062.9 2,217.7
2,101.9
1,540.9
1,099.4
1,578.2
1,106.6
1,176.8
1,145.8
823.5
500.0
1,000.0
1,500.0
2,000.0
2,500.0
3,000.0
3,500.0
2004 2005 2006 2007 2008r 2009r
$ C
urr
ent
Construction Segments. FY 04 thru 09Gross Fixed Domestic Investment
Public Total
Private Housing
Private Industrial andCommercial
-1400
-1200
-1000
-800
-600
-400
-200
0
200
400
600
800
Jan Feb March Apr May Jun Jul Aug Sept Oct Nov Dec
New Housing Units Authorized, Monthly 2007-2008
2007 2008 Linear (2007) Linear (2008)
63
Employment, Wages and Disposable Income.
The reduction in Total Establishment employment during CY08 reached -15,242 jobs, and was led by Services contraction, closely followed by manufacturing and construction losses. See Table 12.
Table 12
During CY 08 establishment Survey employment confirmed sustained monthly reductions. The 2007 annual average level was -15,242 lower than 2006. Compared to CY05 levels, Puerto Rico had lost almost 47,000 jobs.
Graph 54
55
61 61
71
73
78
69
60
50
55
60
65
70
75
80
2003 2004 2005 2006 2007 2008 2009 2010
Average Private Housing Unit Value by FY
Average PrivateHousing Unit Value byFY
Total Manufacturing Construction Services State Govt Other
2007 (20,440) (4,326) (2,858) (3,119) (7,661) -2476
2008 (15,242) (5,467) (5,154) (6,694) (1,213) 3286
Source: US Dept. of Labor, Bureau Labor Statistics, QCEW
Change in Employment, Establishment Survey
64
Graph 55
Graph 56
1,048,004
1,036,802
1,016,362
1,001,120
970,000
980,000
990,000
1,000,000
1,010,000
1,020,000
1,030,000
1,040,000
1,050,000
1,060,000
2005 2006 2007 2008
Puerto Rico, Average Annual Establishment Employment
980000
1000000
1020000
1040000
1060000
1080000
1100000
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Puerto Rico Monthly Establishment Employment 2005-2008
2005
2006
2007
2008
65
Source: US Department of Labor, Bureau of Labor Statistics, Quarterly Census of Employment and Wages
Public Financial Management
CAFR. On June 15, 2008 the audited financials for FY07, confirming the following:
1. The General Fund closing deficit balance for FY07 reached $511M, or 33% worse than in FY06. Year-end deficits would have been even higher had none of the following transactions occurred: $137M from the first year with sales tax revenues; the central government took a $180M loan from the State Insurance Fund and reduced Health care expenditures by $107M. Finally, COFINA bond issue proceeds were used to cover PFC debt service in the amount of $522M.
2. The Governmental Funds balance decreased from $411M in FY06 to a mere $107M in FY07.
General Fund FY08. Total revenues from internal sources dropped by $473M or 6% during FY08, despite the first full year of sales tax revenues, which accounted for $911M. The reduction was led by a significant $421M decrease in the corporate tax revenues of taxable companies affected by the overall slowdown. Tax revenues from exempt companies failed to increase this year, stabilizing at $1.3BN. As we noted before in discussing 2007, exempt companies had increased their tax credit claims and the effect of pharmaceutical contraction continued to be noticeable.
2.6%
2.3%
1.7%
1.4%
1.6%
1.8%
2.0%
2.2%
2.4%
2.6%
2.8%
2006 2007 2008
Total Wages All Industries Puerto Rico
Annual CY % Change 2006-2008
66
Table 13
General Fund revenues from internal sources for FY08 were down sharply or by $-473M, as a result of overall worsening conditions.
Even after the adoption of the sales tax, tax revenues had dropped so drastically that during FY08 the General Fund did a $207M debt refinancing of the GO debt service and multiple other transactions reaching $1BN in an effort to finance the deficit.
Of notice is the fact that the corporate tax revenues from taxable companies had reduced to a mere $292M or less than half the previous year level. Tax revenues from multinational companies also dropped, led by a reduction in income tax, as the General Fund once again relied more on royalties. This was a clear indicator of challenges in both the taxable and tax exempt segments of the economy. See Table 13.
PR Treasury also disclosed in 2008 a sustained reduction in multinational tax revenues, based on the total tax contribution41 as a % of total gross and net taxable income.
41 Includes the assessed contribution, tax on dividend distributions and royalties.
2006 2007 2008
GF Net Revenues from Internal Sources 8,185 8,470 7,997
All Corporate Taxes (GF) 1,872 2,003 1,566
All Corporate Taxes (GF) plus Tollgate Tax 1,899 2,028 1,588
Corporate Taxes from Taxable Companies 621 713 292
Corporate Taxes from Exempt Companies, all
below 1,278 1,315 1,296
Income Tax 505 549 413
Taxes on Royalties 746 741 861
Tollgate Taxes 27 25 22
Act 154 Taxes - - 0
Royalties as % of Total 58% 56% 66%
Fiscal Years
67
Graph 57
Source: PR Treasury Department, Office of Economic and Financial Affairs, December 2008 (See Appendix 5)
Finally, public financial management deterioration eventually led to the elimination of large preferential tax
treatment supporting housing activity. These included:
1. Mortgage interest deduction. The housing bubble and mortgage loan volume growth
was also financed by the General Fund, since all interest income, origination fees and
discount fees without limits (up to assessed market value of the property) were tax
deductible. Second residences used by the owner were also eligible.
2. Limited Partnerships were also used to purchase second homes or rental properties
and deduct interest payments and any losses from individual taxpayers’ taxable
income.42 The only requirement was that 80% of the LP revenues originate from rental
income. Often these properties are related to hotels, which are guaranteed and in
addition subsidized by favorable financing terms guaranteed by the Tourism
Development Fund.
3. Keogh Plans, favored by professionals, were authorized to invest in real estate
properties.
42 No deduction will be allowed for expenses related to the ownership, use, maintenance and depreciation of residential property (located within or outside of Puerto Rico), unless the special partnership has derived 80% or more of its total income from activities exclusively related to the rental of property to non-related persons.
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
1999 2000 2001 2002 2003 2004 2005 2006
Reduced ability to tax multinationals
Total Tax Contributionas % of Net TaxableIncome
Total as % of TotalGross Income
68
Puerto Rico Banking System Performance Data
By year-end 2008, $8.2BN of loans were in past-due and non-accrual status compared to $5.7BN in year-end 2007, up 44%. However, in contrast to 2007, this year the surge even though led by non-accrual increases of $1.3BN, it also came from the PDNA 30-90 ($773M increase) and PDNA 90+ ($453M increase) categories, indicating a broadly worsening scenario.
Graph 58
Total Loans Past Due and Non-Accrual, PR Banking System Dec 2005-Dec 2008
In CY08 PR banks sold and securitized 1-4 family mortgages in the amount of $9.7BN, a peak year,
compared to $6.5BN in 2007 and $5.5BN in 2006.
Table 14
Credit Quality, Real Estate Loans in Domestic Offices, PR Banking System, Dec 2007-Dec 2008
0
1,000,000
2,000,000
3,000,000
4,000,000
5,000,000
6,000,000
PDNA 30-90 PDNA 90+ ANacS
DATEReal estate loans in
domestic offices: 30-89 90+
Nonaccrual
statusTOTAL
PDNA (30-
89)
PDNA
(90+)
Nonaccrual
status
Dec. 2007 39,073,699 1,026,278 166,357 2,935,575 4,128,210 2.63% 0.43% 7.51%
Mar. 2008 40,587,132 1,351,418 182,651 3,212,558 4,746,627 3.33% 0.45% 7.92%
Jun. 2008 40,701,084 1,335,980 193,739 3,429,191 4,958,910 3.28% 0.48% 8.43%
Sep. 2008 40,897,752 1,608,674 241,834 3,600,919 5,451,427 3.93% 0.59% 8.80%
Dec. 2008 40,941,765 1,610,134 561,035 4,290,627 6,461,796 3.93% 1.37% 10.48%
69
Graph 59
Source: FDIC SDI
Total Real Estate Loans secured by 1-4 Family Residential Properties reached $18.4BN by December 2008. But those in PDNA increased by 48% from December 2007 to December 2008 (Table 15), reaching $2.3BN. In CY05, CY06 and CY05 it had also increased by 122%, 45% and 52%, respectively.
The CY07 increase was also led by the non-accrual segment which increased by 58% to reach 1.3BN, making 7% of all Real Estate Loans secured by 1-4 Family Residential Properties reach non-accrual status by December 2008, compared to and 2%, 3% and 5% in December of 2005, 2006 and 2007, respectively.
Table 15
Real Estate Loans Secured by 1-4 Family Residential Properties. 2008
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
PDNA (30-89)
PDNA (90+)
Nonaccrual status
PDNA: Real Estate Loans in domestic offices December 2006-December 2008
DATE
Secured by 1-4
family
residential
properties
30-89 90+Nonaccrual
statusTOTAL
PDNA (30-
89)
PDNA
(90+)
Nonaccrual
status
Dec. 2007 17,060,734 597,264 144,689 795,944 1,537,897 3.50% 0.85% 4.67%
Mar. 2008 18,107,398 651,254 163,179 907,639 1,722,072 3.60% 0.90% 5.01%
Jun. 2008 18,117,706 678,246 164,759 988,754 1,831,759 3.74% 0.91% 5.46%
Sep. 2008 18,401,604 742,134 180,318 1,096,501 2,018,953 4.03% 0.98% 5.96%
Dec. 2008 18,377,163 807,465 211,068 1,257,103 2,275,636 4.39% 1.15% 6.84%
Change
during
period
above
8% 35% 46% 58% 48%
70
That is why in our Introductory Remarks we stress IMF concerns on household finances: “potential public sector costs related to household shortfalls in long-term saving and investment; the broader role of government as “insurer of last resort”; moral hazards, for example, from excessive risk taking by institutions based on the belief that governments will support market values in an effort to protect household balance sheets (i.e., markets are seen as “too important to fail”); and the impact of more direct risk exposures on household behavior, including consumption and saving patterns.”
During CY08, Construction and Land Development loans accounted for 16-17% of all real estate Loans in domestic offices, but those in 90+ and non-accrual status increased dramatically leading to a total of $2.3M in PDNA or 34% of this segment’s total as of December 2008. See Table 16.
Table 16
Construction and Land Development Loans, 2008
As of year-end 2008, the share of all real estate loans within total net loans and leases for the PR banking system remained stable at 68%.
Graph 60 Distribution of Net Loans and Leases by Major Categories, PR Banking System
Key Regulatory Events during 2008. On February 13, 2008 R&G Financial Settles Financial Fraud Charges
With SEC (SEC Litigation Release No. 20455). The SEC filed financial fraud charges against R&G Financial
Corporation for overstating income by approximately $180M by improperly accounting for billions of
dollars’ worth of mortgage-related transactions in 2002, 2003 and 2004. Those accounting irregularities
enabled R&G financial to report an apparent twelve quarter streak of "record earnings." Since the
accounting and disclosure problems began to surface in early 2005, the market price of the company's
DATE
Construction
and Land
Development
Loans
30-89 90+Nonaccrual
statusTOTAL
PDNA (30-
89)
PDNA
(90+)
Nonaccrual
status
Dec. 2007 6,838,882 205,462 12,571 917,524 1,135,557 3.00% 0.18% 13.42%
Mar. 2008 7,014,541 313,951 10,984 1,096,481 1,421,416 4.48% 0.16% 15.63%
Jun. 2008 6,973,322 314,687 6,432 1,128,280 1,449,399 4.51% 0.09% 16.18%
Sep. 2008 6,841,522 317,036 23,762 1,212,567 1,553,365 4.63% 0.35% 17.72%
Dec. 2008 6,692,250 282,312 343,477 1,640,158 2,265,947 4.22% 5.13% 24.51%
71
common stock plummeted from approximately $40 to $10 per share or 75%, thereby reducing equity
market value by approximately $900M. Without admitting or denying the Commission's allegations, R&G
Financial has consented to the entry of a court order enjoining it from violating those antifraud, reporting,
books and records and internal control provisions of the federal securities laws.43
On March 2008 Doral Financial Corp.'s former treasurer was indicted in an alleged scheme to artificially inflate the company's stock price by manipulating the publicly reported value of certain non-cash assets carried on its books, prosecutors said. In a press release, the U.S. Attorney's office in Manhattan said Mario S. Levis, the San Juan, Puerto Rico, financial services holding company's former treasurer and senior executive vice president, has been charged with securities fraud and three counts of wire fraud.44 On September 2008, Banco Popular was unable to place a transaction in the US to raise capital. EDB and GDB purchased $75M and $100M, respectively, in a private placement of Popular Inc. As of June 30, 2009, more than 5% of the EDB’ investments were in Popular Inc. (the Issuer) corporate notes (56.4%), (FS FY09 EDB) From Keefe Bruyette &Woods October 29, 2008 report on Popular Inc. “BPOP issued $250 million of floating rate notes due 2011 in a private offering to institutional investors that bear an interest rate of LIBOR plus 3.25%. It was recently reported in Caribbean Business that the Puerto Rico government purchased $175 million or 70% of the floating notes.”
On December 5, 2008 Popular, Inc. participated in the Capital Purchase Program, issuing $935M in
preferred stock with warrants to the US Treasury.45
During January 2009 First Bancorp also participated in the Capital Purchase Program, issuing $400M in
preferred stock with warrants to the US Treasury.
43 http://www.sec.gov/litigation/litreleases/2008/lr20455.htm 44 http://www.justice.gov/usao/nys/pressreleases/March08/levisindictmentpr.pdf
45 08/24/09, the US Treasury exchanged its series C preferred stock issued by Popular, Inc. for a like amount of non-tax-deductible trust preferred securities issued by Popular Capital Trust III, administrative trustee for Popular, Inc. Popular, Inc. paid a $13 million exchange fee in connection with this transaction.
72
Appendix 1 US Large Cap Pharma R&D Spend and Net Innovation (revenues from new approved products). Puerto Rico Chemical Employment PR Fiscal Years, Establishment Survey, Bureau of Labor Statistics, 2002 thru 2011
Source: US Dept. of Labor, Bureau of Labor
73
Appendix 2
Source: GDB
74
Appendix 3 Puerto Rico, State and Local Government Employment, Calendar Years 1997 to 2005 US Department of Labor, Bureau of Labor Statistics
126649
135830
121542
110000
115000
120000
125000
130000
135000
140000
1997 1998 1999 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
PR State Government Employment CY BLS
55686
60234
62571
57497
52000
54000
56000
58000
60000
62000
64000
1997 1998 1999 2001 2002 2003 2004 2005 2006 2007 2008 2009
Local Government Employment (Municipios) CY BLS
75
Appendix 4
Source: Bureau of Labor Statistics, Extended Mass Layoffs (1999-2008)
http://www.bls.gov/mls/archivedreports.htm, accessed October 26, 2013 Note: Figures were sometimes revised, in all cases listed
figure is the last reported by BLS.
55,243
17,330.00
8,000
13,000
18,000
23,000
28,000
33,000
38,000
43,000
48,000
53,000
58,000
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Num
ber
as
per
BLS
PR Mass Layoffs, Unemployment Insurance Claims
continued claims withoutearnings, number
total initial claimants forunemployment insurance
76
Appendix 5 PR Treasury Department Reduction in multinational tax revenues, based on the total tax contribution as a % of total gross and net taxable income
Variables 1) 1999 2000 2001 2002 2003 2004 2005 2006
Total de Ingreso Bruto 29,359 29,861 28,978 33,763 35,190 33,385 35,767 35,479
Total Gross
Income
Deducciones al Ingreso Bruto 11,709 12,700 11,590 12,454 15,368 13,378 13,697 10,068
Gross Income
Deductions
Deducciones Especiales y otras 4,822 2,384 1,273 1,308 1,012 1,113 699 652
Special
Deductions and
Related
Ingresos Netos sujeto a Contribución 12,827 14,776 16,115 20,001 18,809 18,686 21,100 23,932
Net taxable
Income
15.2% 9.1% 24.1% -6.0% -0.7% 12.9% 13.4%
Contribución Determinada 757 691 627 698 603 532 507 558
Assessed
Contribution
Tollgate Tax (Regular y Prepago) 2) 115 111 50 60 45 32 23 27
Tax on Dividend
Distributions
Retenida a No Residentes 3) 301 426 582 395 293 410 413 746
Withheld to non-
residents (royalty
Créditos Contributivos 14 46 10 29 30 27 25 28
Minus Tax Credits
Claimed
Total Contribución 1,159 1,182 1,249 1,124 911 947 918 1,303
Total Tax
Contribution
Total as% of Total Net Taxable Income 9.0% 8.0% 7.8% 5.6% 4.8% 5.1% 4.4% 5.4%
Total as% of Total Gross Income 3.9% 4.0% 4.3% 3.3% 2.6% 2.8% 2.6% 3.7%
Notas:
2004-2006 estimado a base de muestra representativa,
2) Ingresos del Fondo General 1999-2006.
3) Basado en pagos de regalías por las corporaciones organizadas como CFC "Controlled Foreign Corporations"
Información a diciembre de 2008, cifras sujetas a revisión.
1) Información revisada de las planillas para años contributivos 1999-2003,
Departamento de Hacienda
Oficina de Asuntos Económicos y Financieros
Datos Contributivos Seleccionados
Negocios Exentos bajo el Programa de Incentivos
Años Contributivos - millones de dólares
77
Appendix 6
Summaries and Extracts of IMF Global Financial Stability (GFSR) Reports 2002-2005
GFSR December 2002 The market declines in recent years has weakened the balance sheets of financial institutions, corporations, and households, increasing their vulnerability to additional asset price declines. Low interest rates and a steep yield curve have helped support banking sector profitability and rising house prices, in part supported by low rates. A prolonged deterioration in the operating environment of major financial institutions could undermine their profitability and credit quality, and spur further retrenchment of risk taking by financial intermediaries. The growing reliance by financial institutions on credit risk transfer markets to manage their risk exposure necessitates better disclosure and regulatory scrutiny to ensure that these markets and instruments continue to work as intended should the credit deterioration persist. The U.S. household sector remains critically important to the global financial system's capacity to assume and intermediate risks. So far, U.S. households have continued to underpin economic activity and bear financial risks. They have suffered significant losses from the deterioration in financial markets since households own (directly or indirectly) the lion's share of U.S. corporate and financial sector risks in the form of bond and equity investments. Financial institutions are striving to improve how they manage and price credit and other risks. Partly reflecting the effects of recent credit shocks, banks are moving toward an active “credit portfolio” approach, rather than using their balance sheets as a passive repository of credit risk. This ranges from more aggressive management of wholesale and retail loan exposures, to greater attention to counterparty risk exposures in the interdealer over-the-counter (OTC) derivatives. Heightened attention to credit risk management could make credit terms for riskier borrowers more risk sensitive to cyclical conditions and therefore more pro–cyclical. Improved credit risk management will mean greater reliance on credit derivatives markets. In the United States in particular, the adverse effects of stock market declines on households' financial conditions have been at least partly offset by a combination of strongly rising real estate prices and low or declining interest rates. This continued debt growth has reflected sustained mortgage refinancing activity, which attained new records as rates hit multi–decade lows. The financial institutions on the other side of these transactions may now be more exposed to interest rate risk. If downside risks to the economic outlook materialized, higher unemployment and slow or negative real income growth would adversely affect the financial resilience of highly indebted households. The considerable rise in U.S. housing prices during recent years, which occurred in an environment of strong housing demand and historically low and falling interest rates, has raised questions about whether this rise is sustainable or whether it is displaying characteristics of a “bubble”. These questions are important, because so far rising housing prices have bolstered household wealth, helping to offset the erosion of net worth from falling equity prices. Accordingly, a downturn in housing prices—possibly sparked by higher interest rates—could add to downward pressure on net wealth, and might reduce household willingness to take financial market risks. While the risk that U.S. housing markets are experiencing an unsustainable bubble cannot be ruled out, several factors suggest that the strength in U.S. residential real estate markets reflects economic and demographic factors, and therefore fundamental strength in demand for housing, rather than speculative and unsustainable demand.
78
Considering that equity and real estate holdings comprise a substantial share of household assets, a key risk is that stock and housing prices could grow more slowly or decline if downside risks to the economic outlook are realized, adding to the adverse effects of higher unemployment and slower income growth. Another risk is that, with debt at record levels, an increase in retail interest rates could increase the household debt burden. Refinancing activity at fixed rates has reduced vulnerability to this risk, moving interest rate exposure into the financial sector, Nevertheless, rising interest rates could also dampen equity and real estate prices, potentially eroding household assets. Particularly if the economy is in an environment of softer income growth and heightened employment uncertainty, any of these outcomes could reduce U.S. households' ability or willingness to take financial market risks or, in a worst case scenario, could even lead households (and the institutions that administer their pensions) to shed riskier assets to safeguard net wealth. Moreover, a more general investor retrenchment of risk taking could limit banks' ability to continue to lay off credit risks in the markets. GSFR September 2003 Fannie Mae and Freddie Mac The prospect of a protracted period of low short-term interest rates and ample liquidity sparked investors' quest for yield that proceeded progressively out along the risk spectrum. Unless economic growth decelerates substantially, however, weak earnings growth is unlikely to pose a serious threat to the resilience of the international financial system. Having strengthened their balance sheets, most corporations and financial institutions are now better prepared to cope with slower growth than they were last fall. Rising interest rates could also undercut property prices, undermining the net worth of the household sector, whose exposure to real estate has increased with the refinancing and house price boom. Under this scenario, U.S. mortgage agencies (Fannie Mae and Freddie Mac) would need to engage in continuous hedging, as rising rates would rapidly increase the expected duration of their portfolios of mortgage–backed securities from relatively low levels. The liquidity of the markets for fixed–income cash and derivative instruments has come under pressure given the hedging need for the unprecedented size of holdings of mortgages and mortgage-backed securities. By virtue of their size, rapid growth, high leverage, and complex hedging of interest rate risk, the U.S. mortgage agencies warrant careful monitoring. Such monitoring should include an assessment of whether these agencies are sufficiently capitalized against the shocks arising from fast-moving markets. Thin capital coverage can increase the pressure on these agencies to conduct continuous hedging strategies that have the potential to amplify interest rate movements. Fannie Mae and Freddie Mac have come under increasing scrutiny because of their rapid growth and the risks they pose to financial stability. Recent developments have highlighted the extremely large, highly leveraged, nature of these enterprises and the risks they are managing. The ability of homeowners to fix their mortgage rates while preserving prepayment rights has transferred complex and increasingly large risks to these enterprises and other investors. While it is prudent for Fannie Mae and Freddie Mac to hedge their exposures, the very large size of their balance sheets implies that their hedging operations can accentuate sharp market moves. Some observers have warned of the systemic risks inherent in the agencies' large mortgage portfolios and their hedging operations, and have criticized the agencies for lack of transparency. In addition, it is unclear
79
whether they have taken sufficient account of the risk that the markets may not be deep enough to allow them to continuously hedge their growing portfolios in times of stress. The size of mortgage indebtedness and recent historically low interest rates greatly increased the volume of prepayments to be hedged in the last three years. Therefore, the effect of these prepayments, and the consequent need for hedging transactions, has become a more important issue for financial stability. As dynamic hedgers see the expected duration of their assets increase when interest rates rise and the likelihood of prepayments falls, they will reduce duration elsewhere on their balance sheet by, for example, selling treasury securities, thus potentially accelerating the upward movement in yields in the overall market. Regulators should closely examine whether the agencies’ capital base is large enough to absorb the risks on their growing balance sheet because of volatile market environment for the agencies, potential difficulties for the market in absorbing their hedging needs, and possible lower profit margins. The narrowness of the safety margin provided by their capital has increased the need for them to maintain precise hedges on a continuous basis. The continuous, non-discretionary hedging by the agencies and others in the mortgage market could amplify the size of any future increase in interest rates and add to market volatility. GFSR April 2004 There is much liquidity in the market and that has contributed to investors not paying attention to economic fundamentals. In seeking profit they are driving up the value of various types of assets. In recent years the risk from the banking sector has been transferred to other sectors in the economy, which, although apparently strengthening the tolerance of the sector to severe shocks, the risk has been transferred from a regulated sector to unregulated ones. This risk stops at the latest financial system users, so households and public and private entities will be more directly exposed to financial risks. The increased exposure of households to risks in the financial sector may cause governments to feel pressured to inject liquidity to protect this group from sustained losses in asset values. This can create a "moral hazard", not of having to save financial institutions, but asset classes (markets "too important to fail"). "Regulators and supervisors in the financial sector also need to be alert to possible mispricing of risk, excessive buildup of leverage, or concentrated risk exposures." (Page 6, GFSR, April 2004) “Policies pursued to stimulate economic growth also created powerful incentives for investors to venture further out along the risk spectrum and contributed to a recovery of asset valuations.” (Page 8, GFSR, April 2004) “U.S. commercial banks posted strong earnings through the end of 2003, largely reflecting continued strong mortgage demand and a pickup in capital market activities among money-center banks. However, demand for business loans remained weak, and the volume of commercial and industrial loans fell further through the fourth quarter of 2003, although there are signs that demand for borrowing may improve in 2004 as economic activity strengthens.” (Page 45, GFSR, April 2004) “Rating agencies may have to adapt their assessment procedures to adequately monitor complex ownership structures with global operations and relatively more sophisticated treasury operations compared to industry norms.” (Page 57, GFSR, April 2004) GFSR September 2004 It is not easy to determine where the systemic threats in the short term are. The biggest risk could be that investors keep chasing profits, which would have a global impact given the increasing number of international investors. The markets are increasingly moving to a "common pool of global savings". Pension plans are a very large investor and their redistributions of investment assets, even if not large positions, can have great impact in illiquid markets.
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GFSR April 2005 The proportion of liquid assets to debt in the corporate portfolio has increased, and has had the effect of reducing the creation of jobs. There are several risks that could affect the system. One of them is that because the inflation risk and credit risk premium do not have much margin for error, the market may not be ready for a sharp increase in long-term interest rates. Another factor is the proliferation of derivatives and the impossibility preparing models due to the complexity of these instruments. Market participants should perform counterparty analysis. Also, regulators should be aware of the risk profile of financial intermediaries, especially because the financial models developed have not been tested in a real situation. The financial risk that has been transferred to households is an important factor because of the costs they have had to assume regarding retirement, health and education. The majority of households have not realized the risk they have assumed. There have not been public policies adopted to help households to cope with these new risks, especially measures to incentivize savings and to promote financial education. The financial system, as well as insurance companies and pension systems, have been strengthened by transferring the risk they had, but have made households more vulnerable, as they are now subject directly to financial risks: on page 5: “The household sector has increasingly and more directly become the “shock absorber of last resort” in the financial system”. A strong shock to households could create pressure on governments to be an “insurer of last resort” and to approve regulations and restrictions to the financial industry. “Policies designed to improve the financial stability of systemically or otherwise important institutions need to also consider the consequent flow of risks to households and their ability to absorb or manage such risks. Households are relevant to the financial stability debate in numerous ways, including the following considerations: (1) potential public sector costs related to household shortfalls in long-term saving and investment; (2) the broader role of government as “insurer of last resort”; (3) the need to facilitate or more actively develop markets and market solutions, or alternatively, to re-regulate institutional behavior to achieve the desired risk sharing; (4) moral hazards, for example, from excessive risk taking by institutions based on the belief that governments will support market values in an effort to protect household balance sheets (i.e., markets are seen as “too important to fall”); and (5) the impact of more direct risk exposures on household behavior, including consumption and saving patterns.” (Pages 63-64, GFSR, April 2005) May 2005: triggered by credit events at GM and Ford, hedge funds find it most difficult to exit or hedge equity tranche market portfolio swap positions because their dealer counterparty often had similar liquidity needs. Marco hedge funds with more diverse investment strategies and hedge funds with access to new capital entered the market as they perceived prices to be well below fundamental levels, helping to provide liquidity and restore stability. GFSR September 2005 The corporate sector is, on a net basis, an investor, because it is not borrowing. This situation makes it vulnerable to the same risks faced by institutional investors, and in an environment of increasing use of derivative instruments. It is important to monitor mortgages that postpone payments to future years and regulators need to make sure banks are not relaxing credit lending criteria. Regulators have to also keep abreast with new instruments and the complexity of the system, in addition to monitoring each bank’s counterparty risk control system. The transfer of risk from banks to insurance companies and pension systems has moved these entities to the center of the financial system. “Indeed, it is now virtually impossible to conduct multilateral surveillance in financial markets at large and not to understand the intricacies of nonbanks’ investment decisions and their motivation” (Page 6, GFSR, 2005)