Analysis- Puerto Rico debt crisis headed for US-style bankruptcy resolution

By Nick Brown and Tom Hals (Reuters) - Momentum is building towards a deal that would make painful losses inevitable for investors holding about $20 billion (11.7 billion pounds) in bonds issued by Puerto Rico's highway, water and electricity authorities even as some big U.S. mutual funds launch a legal battle to squelch a new law that authorizes a restructuring. The Puerto Rican government and most of its creditors have hired U.S.-based bankruptcy experts to advise them through the Caribbean island’s efforts to solve its debt problem, and the resolution figures to look a lot like a U.S.-style bankruptcy. The crisis came to a head late last month when Governor Alejandro Garcia Padilla pushed through the Public Corporations Debt Enforcement and Recovery Act to create a bankruptcy-like process for restructuring the debt of commonwealth-run corporations. That’s caused prices on some of the bonds of the electric utility, known as PREPA, to fall to 40 cents on the dollar or below. PREPA is widely viewed to be in the weakest condition of the agencies. Municipal bond mutual funds including Oppenheimer & Co. and Franklin Templeton sued to block the law. Some of their funds have suffered negative returns since the Recovery Act triggered the decline in Puerto Rico bonds, a long-time favourite among fund managers thanks to their triple tax-free status and fat yields. Supporting the law is a group of distressed debt investors who bought more than $3 billion of Puerto Rico’s general obligation (GO) and governmental development bank (GDB) bonds, which can't be restructured under the law. Padilla is trying to protect the commonwealth’s ability to make payments on about $52 billion of bonds not subject to the law by restructuring the debt of agencies like PREPA and the sewer and water authority known as PRASA, said Suzzanne Uhland, a lawyer and municipal insolvency expert at O'Melveny & Myers in San Francisco. "What the commonwealth is trying to signal is that they are going to let PREPA and PRASA go under but they will stand behind the GO and GDB bonds," she said. Late last week, the distressed debt investors who bought the GO and GDB bonds said they had formed a committee in support of the new law. The formation of such groups, which are a staple in big bankruptcy cases that involve disparate creditor factions, is an indication of a restructuring in its infancy, restructuring specialists said. One key role for the committee in Puerto Rico, which includes Fir Tree Partners and Aurelius Capital Management, among others, could be to finance a restructuring for PREPA through a so-called debtor-in-possession, or DIP, loan. Early projections peg a DIP for PREPA in the $1.5 billion to $2 billion range, people close to the matter have told Reuters. With prospects that the situation will unfold like a U.S.-style bankruptcy, top turnaround experts have jumped into the fray. Puerto Rico's government development bank has hired Jim Millstein, who oversaw the U.S. rescue of American International Group. Lawyers at Cleary Gottlieb Steen & Hamilton, which has advised Greece and Argentina, teamed with Proskauer Rose's Martin Bienenstock, the bankruptcy expert who helped structure the auto bankruptcies of 2009, to write the bulk of the new bankruptcy law. MBIA Inc and Assured Guaranty Ltd , bond insurers with more than $10 billion in combined exposure to Puerto Rico, are being represented by financial advisers with workout expertise at The Blackstone Group and Houlihan Lokey, respectively. The three have a combined exposure of $2.4 billion to PREPA, according to Moody’s Investors Service. Others involved include law firms Weil, Gotshal & Manges, which took Lehman Brothers through bankruptcy, Debevoise & Plimpton, which was involved with American Airlines' Chapter 11, and Cadwalader, Wickersham & Taft, which has been involved in Detroit's bankruptcy. CHRONIC DEFICITS The restructuring efforts follow a decade during which an index of the island's economic activity has fallen by 18 percent and the number of employed people has fallen by 11 percent. The government runs chronic budget deficits and has a weak track record for collecting everything from sales and corporate income taxes to power and water bills. To plug the gap, the government and its agencies have turned repeatedly to the $3.7 trillion U.S. municipal bond market, eventually amassing a collective debt of $72.6 billion. Padilla, who took office in January 2013, has been aggressive in addressing the island's fiscal crisis, raising taxes, reforming public pensions and slashing spending. But his move to push through the restructuring law last month shocked investors. Prices on PREPA bonds and those issued by its sister corporations plunged, with some PREPA debt falling by nearly 50 percent in a matter of days. Credit ratings agencies, which had already cut most Puerto Rico bonds to below-investment grade earlier in the year, slashed them deeper into junk territory, saying the law raised questions about the administration's commitment to honouring its debts. The upshot has been a shift in ownership of Puerto Rico bonds away from risk-averse investors to hedge funds who are accustomed to uncovering ways to profit from bonds trading at deeply discounted levels. "There's no way any traditional investor is buying at 40 cents on the dollar," said David Tawil of Maglan Capital, a distressed debt hedge fund. Hedge funds buying the distressed PREPA debt may open the way to a debt-cutting deal, given that they specialise in finding "collaborative solutions that will assist in any restructuring," said Laurence Gottlieb, the chairman and chief executive officer of Fundamental Advisors, which focuses on municipal markets. Many hedge funds are accustomed to plowing more money into a situation if it offers a chance of boosting their returns, and due to the current dearth of big corporate bankruptcies, funds are scrambling for investment opportunities. AVOIDING BAILOUTS That could be a boon for PREPA as it needs to convert to natural gas-fuelled plants but is unlikely to get financing from traditional muni investors who may now shun all things Puerto Rico. The island commonwealth also must borrow to pay for the oil it uses to fire its generators. The power company already has had to arrange a deferral of payments on expired bank lines of credit. The grace period expires on July 31, and $696 million is owed its banks in August, unless it can negotiate new credit terms or forbearance agreements. PREPA said it would use the grace period to "evaluate various alternatives to improve its financial position." Indeed, a restructuring of PREPA's debt could provide relief for the bonds owed directly by the island's government. Puerto Rico has committed to repaying its general obligation bonds, a promise it never made for PREPA and the other public corporations. Treating those corporations as if they were private businesses assures investors the commonwealth government won't tie up its limited funds with bail-outs. Puerto Rico's debt becomes more manageable once it cuts the debt associated with its three biggest public corporations. Recent market activity suggests some investors believe that could well be the case. While many long-term PREPA bonds remain at prices in the mid-40s or below, the commonwealth's general obligation bonds have rallied. Prices on its benchmark offering of $3.5 billion of GO bonds sold in March -- the largest municipal junk bond offering in history -- have risen from as low as 83.5 cents on the dollar shortly after the law was enacted to nearly 90 cents on Tuesday. BATTLE AHEAD Still, it's clear that some investors aren't ready to simply accept the inevitability of a restructuring. Oppenheimer and Franklin allege in their lawsuit that the Recovery Act violates the U.S. Constitution on multiple fronts, including by allowing the commonwealth to impair contracts over the objections of certain bondholders. "A state law may not force a municipality's secured bondholders to accept a composition of their indebtedness merely because other holders have voted to do so," Franklin and Oppenheimer said in their June 29 complaint. The government responded to the lawsuit in federal court in San Juan, the island's capital, on Monday, saying it should be dismissed as untimely because PREPA has not yet sought to use the provisions of the Recovery Act. Indeed, the aggressive measures taken by Padilla have won some admirers among the new ilk of investors. "The assumption that Puerto Rico is just terribly broken and needs to restructure immediately is false," Eli Combs, whose distressed investment fund, Meehan Combs, owns Puerto Rico general obligation bonds, but not PREPA bonds. Combs said the commonwealth bought itself breathing room earlier this year with the bond sale and circumstances would have to change drastically before a reckoning is inevitable. He said Puerto Rico "is taking real actions to fix an economy that's existed for hundreds of years." (Reporting by Nick Brown and Edward Krudy in New York and Tom Hals in Wilmington, Delaware. Editing by John Pickering)