How Puerto Rico's Banks Avoided Disaster from Territory's Default

A proactive approach by Puerto Rico's banks should help them weather the territory's biggest economic crisis to date.

Puerto Rico on Monday appeared to take the first turn of what Gov. Alejandro Garcia Padilla predicted would be a financial "death spiral," after its financial arm defaulted on a $58 million payment to bondholders, paying only $628,000 in interest.

Financial institutions on the island, however, have been making moves in recent years to reduce their exposure to government securities. As a result, most industry observers said they believe the issue will serve as just another twist in a region where uncertainty and upheaval appear to be the norm.

"A default like this is never a positive, but putting it in context of what the island's economy has been through for the past seven years, it's not a big surprise," said Gerard Cassidy, an analyst at RBC Capital Markets.

"I think the impact is minimal, if anything," added Brian Klock, an analyst at Keefe Bruyette & Woods, discussing the impact the default could have on Popular Inc., the parent company of Puerto Rico's biggest bank.

Popular has reduced its exposure to government securities in recent years, Richard Carrion, the $35 billion-asset company's chairman and chief executive, said during a conference call last month to discuss quarterly results. "Keep in mind that that the majority of our direct Puerto Rico exposure is in loans to municipalities, not in publicly traded securities of the central government," Carrion said.

Puerto Rico's municipalities operate autonomously from the territory's government and its public corporations, and most carry lighter debt loans, Jose Rafael Fernandez, OFG Bancorp's vice chairman, president and chief executive, said during the $7.3 billion-asset company's quarterly conference call.

Popular, meanwhile, has $673 million in direct exposure to the Puerto Rican government, but only about $50 million involves investment securities, Klock said, adding that the company has agreed to sell a majority of its exposure to the troubled Puerto Rico Electric Power Authority, or PREPA.

Popular's executives also noted during the quarterly call that the company's recent stress test showed it could handle the indirect fallouts from the debt crisis, including up to 20% unemployment — a possibility if the government shuts down — and a 6% decline in economic activity.

If the past few years have been any guide, Popular is well-versed in how to handle a sluggish economy, Carrion said. "We have operated in a weak economy for the past nine years," he said, pointing to the company's profitability.

"Popular is sitting in an all-things-considered good position," Alex Twerdahl, an analyst at Sandler O'Neill, said. "They went through DFAST with plenty of extra capital."

OFG and First Bancorp also have limited direct exposure to the territory's government, industry experts said.

The $12.6 billion-asset First Bancorp has about $378 million in direct government exposure, including loans to municipalities, public corporations and the central government, in addition to government securities, said Taylor Brodarick, an analyst at Guggenheim Securities.

Such exposure should be manageable, especially since the largest piece, about $204 million in loans to municipalities, is backed by property taxes based on 1960 valuations rather than years when the economy had been stronger, Brodarick said.

"It is prudent to be cautious about all levels of exposure," Brodarick said. First Bancorp, OFG and Popular "have worked hard to derisk their direct exposure to Puerto Rico."

OFG has about $515 million in exposure to public debt, including roughly $214 million in loans to municipalities, Brodarick said. OFG's executives sought to reassure analysts during its quarterly earnings call, noting that the loans involve the island five biggest municipalities, are were underwritten by its own standards and are not traded as municipal paper. The loans are also guaranteed by a first lien on property taxes, along the funds set aside in a special escrow account.

OFG, for instance, noted during its recent earnings presentation that it had reduced its exposure to central government and public corporation loans by 21% during the second quarter, and by 60% since late 2013, to about $301 million.

"We cannot control what the Puerto Rico central government will do in their negotiations with the bondholders," Fernandez said during the call. "So our strategy is to approach the next few quarters cautiously, continuing to seek opportunities to further derisk the balance sheet and, as an example, reevaluating alternatives to dispose of covered nonperforming commercial loans."

"We feel very comfortable with our exposure to municipalities," Aurelio Aleman, chief executive of First Bancorp, said during his company's conference call. "These municipalities are well-managed entities."

Puerto Rico's banks have also tried to limit their overall exposure to the ongoing fiscal crisis. For instance, Popular's exposure declined roughly 17%, to $673 million, during the second quarter, Brodarick said. It will decline even more once the company sells its $75 million participation loan to PREPA for $45 million.

PREPA also owes $75 million to First Bancorp and $200 million to OFG, and it would be prudent for each lender to follow Popular's lead by accepting a haircut on the credit, Brodarick said.

Management teams seem to be prepared to handle the continuing depressed economy, Brodarick said. Overall the banks have stockpiled capital and have been conservative in their stress-testing scenarios. "During my conversations with management teams, none have suggested that there's a deterioration in credit quality from the fiscal situation," he said.

Another concern is what would happen to consumer credit if the Puerto Rican government temporarily shuts down and cannot pay its workers. Executives said they have been running tests on their portfolios to make sure they can handle such a scenario.

Still, some industry observers said they are concerned that continued weak economy could eventually have an effect on the island's battle-hardened banks.

The problems with the government will likely cause Puerto Ricans to be reluctant to start businesses or make investments in existing ones, said Bert Ely of Ely & Co. In addition, residents may be unable to build or buy homes because of continued uncertainty, which could become even worse as the territory's population continues to decline.

"Banks tend to be a mirror of the economies they are serving," Ely said. "The real concern is the continuing population drain. That shrinks the business base of the banks."

For many industry observers, the next big thing to look forward to is the release of a fiscal reform plan, currently set for Aug. 30, being worked on by a group formed by Padilla's office.

"There's going to be a lot happening in the next month or so," Klock said, adding that the default is just the first step in a long process of negotiations.