February 21, 2013 / 7:56 PM / in 5 years

TEXT - Fitch may cut Puerto Rico's commonwealth GO bonds

Feb 21 - Fitch Ratings has placed the 'BBB+' ratings of the following
Commonwealth of Puerto Rico debt on Rating Watch Negative:

--Commonwealth general obligation (GO) bonds;

--Puerto Rico Building Authority government facilities revenue bonds guaranteed 
by the commonwealth;

--Puerto Rico Aqueduct and Sewer Authority (PRASA) commonwealth guaranty revenue
bonds; 

--Employees Retirement System of the Commonwealth of Puerto Rico pension funding
bonds.

The Rating Watch Negative reflects Fitch's expectation of a significant increase
in the commonwealth's estimated operating imbalance for the current and coming 
fiscal years, based on reported revenue results through the first half of the 
current fiscal year and public statements by the new administration.  Fitch 
expects to resolve the Rating Watch early next month following meetings with 
representatives of the commonwealth.

SECURITY 

The GO bonds are a full faith and credit obligation of the Commonwealth of 
Puerto Rico that benefit from a constitutional first claim on commonwealth 
revenues.  The ratings on the building authority and PRASA bonds reflect the 
guaranty of the commonwealth's full faith, credit, and taxing power.  The 
pension funding bonds are payable from and secured by a pledge of statutorily 
required employer contributions to the system; the commonwealth is the largest 
contributor.

KEY RATING DRIVERS

--SIGNIFICANTLY INCREASED BUDGET CHALLENGE: The Negative Rating Watch is based 
on the economic and revenue underperformance which Fitch believes has 
meaningfully increased the size of the operating imbalance for the current 
fiscal year and the gap the commonwealth will need to address as it develops a 
budget for 2014.  Fitch does not believe that a balanced budget will be achieved
in fiscal 2014, and meeting this goal will remain challenging thereafter.  

--WEAK ECONOMIC PERFORMANCE: The commonwealth's economy is limited but closely 
linked to that of the U.S.  The downturn in Puerto Rico started earlier, was 
deeper, and lasted longer than the U.S. national recession. After signs of 
stabilization in 2012, recent performance has shown some weakening.  

--VERY HIGH LIABILITIES & POOR PENSION FUNDING: Puerto Rico's bonded debt levels
are exceptionally high and pension system assets are expected to be depleted in 
the foreseeable future absent significant reform. These high liabilities both 
limit Puerto Rico's ability to use additional leveraging for capital 
improvements or as a budget solution and create spending pressures that will be 
difficult to absorb within slowly growing revenues. 

--IMPROVED FINANCIAL MANAGEMENT: Commonwealth financial operations historically 
have been weak, with a record of large budgetary and GAAP deficits, 
overestimation of revenues, unfunded overspending, and a reliance on borrowing 
to meet budgetary gaps. The last administration took dramatic steps to 
restructure fiscal operations and stimulate the economy, and demonstrable 
progress was made.  The new administration appears to be continuing this focus. 


RATING SENSITIVITIES    

Future rating action will be driven by Fitch's assessment of additional 
information the agency expects to receive in the near term regarding the scope 
of the commonwealth's current fiscal challenge and the new administration's 
plans to address it.

CREDIT PROFILE

Puerto Rico's GO rating reflects the somewhat limited nature of its economy, its
strong ties to the U.S., a history of weak financial operations, and very high 
liabilities including outstanding debt and unfunded pensions. Strong legal 
provisions for GO debt include a constitutional first claim on commonwealth 
revenues, including transportation-related and rum excise tax revenues that are 
dedicated to specific authorities and other bonds. 

Despite four years of aggressive cost cutting and other fiscal restructuring 
measures by the last administration, economic recovery and budget balance have 
proven elusive.  Fitch has noted steady progress in stabilizing the 
commonwealth's finances; however, with a reduction in near-term expectations for
the economy and revenue underperformance in the current fiscal year to date, the
budget challenge facing the new administration has expanded considerably 
compared to original estimates.  The current-year deficit appears to be well 
above the $1.1 billion originally forecast (including debt refinancings for 
budget relief).  Fitch will be meeting with representatives of the commonwealth 
early next month and expects to receive detailed updated information on the 
fiscal situation and the administration's plans at that time. 

A proposal on pension reform also seems to be forthcoming.  Pension funding is 
exceptionally low. System contributions are defined by law rather than by 
actuarial requirements and payments have not been covering the actuarially 
determined annual required contribution or even current benefit payments.  The 
commonwealth's ability to take action that supports the solvency of the pension 
system without significantly increasing the demands that pensions place on the 
budget will be critical to long-term rating stability.

Puerto Rico's debt levels are very high, partially reflecting the consolidated 
nature of the central government's role, and have increased as the commonwealth 
has used deficit financing as part of its fiscal stabilization plan. The 
commonwealth utilizes a complex debt structure that includes GO, sales tax, 
guaranteed, and public corporation debt, and has relied heavily on borrowing 
under its various bonding programs in order to fund operations. Although such 
borrowing has been reduced, continued reliance on capital markets to refinance 
debt for current-year budget savings introduces risk to operations and increases
the already high debt burden. The commonwealth benefits from its relationship 
with the Government Development Bank for Puerto Rico, which provides a degree of
flexibility and liquidity. 

Puerto Rico faces a longer term question of how to grow and diversify its 
economy, increase employment and workforce participation levels, enhance wealth 
and income, and address contraction in its existing pharmaceutical and 
electronic-producing industries. The ultimate test of the success of future 
policy will be whether or not Puerto Rico is able to find a sustainable path to 
economic growth, growth that is necessary to support the commonwealth's high 
debt levels and other long-term liabilities, as well as to achieve and maintain 
a structurally balanced budget.

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