Market Confident in Bond Insurance Amid Puerto Rico Turbulence

Puerto Rico's insured bonds strengthened with the general municipal market Monday, signaling confidence in municipal bond insurance as investors reacted to the governor's call for a comprehensive restructuring of the island's debt.

"Overall, the muni market is around five basis points stronger today," a representative from Markit said, referring to bond yields. "There are no notable trades on insured Puerto Rico bonds, but I am seeing a few quotes three to five basis points stronger from where they were evaluated on Friday. We are not seeing insured paper fluctuate the way we are seeing the uninsured paper move."

As of March 31, Assured Guaranty Ltd. had approximately $4.9 billion in consolidated net par exposure to Puerto Rico issuers within three of its insurance subsidiaries. This exposure has increased by $420 million due to Assured's purchase of Radian Asset Asssurance Inc. on April 1.

As of March 31, National Public Finance Guarantee, the muni only arm of MBIA Inc., had about $ 4.5 billion of exposure to Puerto Rico and $4.9 billion of exposure including accreted interest on insure zero coupon capital appreciation bonds. The exposure was transferred to National in 2009 via a reinsurance agreement with MBIA Insurance Corp. Build America Mutual has no exposure to Puerto Rico.

Puerto Rico Gov. Alejandro García Padilla said the island's $72 billion of debt is not payable and that the commonwealth would likely seek significant concessions from creditors, which could include putting off some debt payments for as long as five years.

"The Governor's recent statement on Puerto Rico's inability to repay its debt contradicts his prior statements," said Robert Tucker, managing director, investor relations and communications for Assured. "Puerto Rico feels economic growth would provide a solution to its current financial and economic situation. Financial investment typically involves long-term financing, which is normally provided by the market, to fuel growth. It is inconsistent to think that such investment will be provided by the market if Puerto Rico fails to pursue a consensual solution to its existing financial condition."

Tucker also said that Assured will continue to negotiate in good faith but will not hesitate to fully exercise all of our right and remedies.

"As always, investors in Assured Guaranty insured bonds can rely on our $12 billion in claims-paying resources and unconditional and irrevocable guaranty of the scheduled payment of principal and interest when due," he said.

National also released a statement due to the news.

"National Public Finance Guarantee Corp. will continue to work with the appropriate parties toward a solution that addresses Puerto Rico's significant fiscal and operational difficulties while respecting the rights of creditors," a spokesperson from National said. "In the meantime, National will ensure that its policyholders will continue to receive all of their scheduled interest and principal payments on time and in full."

Assured's shares plunged about 14%, while MBIA's dropped almost 22% close to closing time on Monday following the governor's comments.

Credit swaps tied to Assured and MBIA have been steadily climbing for the past year, which usually denotes the credit risk increasing. From June 30 of 2014 to June 26 of this year, credit swaps tied to Assured have jumped 23 basis points to 369. Credit swaps tied to MBIA have jumped 128 basis points in the same period of time.

Howard Cure, director of municipal research at Evercore Wealth Management, LLC, said that it is hard to say which of the largest individual exposures is the most vulnerable without hearing a speech by Governor, scheduled for 5 p.m. eastern time Monday.

"These issuers are much more inter-related since, for example, [Puerto Rico Electric Power Authority]'s problems partially stem from the Commonwealth's own protection of its liquidity and, as a result, making late payments to PREPA," said Cure. "We would have to see what impact a restructuring would have on surplus reserves and statutory capital. Could losses result in a downgrade? Even if the insurers were to maintain their ratings, what would be the market reaction to purchasing and valuing insurance?"

Cure said it's critical to the long-term financial viability of insurers to be able to continue to underwrite new business. Otherwise, they could be in a run-off scenario and might have to go through remediation to determine how much payout on the dollar would be available, particularly if there are significant losses due to Puerto Rico.

"National is vulnerable since they are trying to reenter the market after years of being dormant," Cure said. "The last thing they need is a rating agency downgrade."

According to a Barclays report on June 24, net charges aggregating $750 million or more would materially damage MBIA's capital base and potentially cause rating downgrades and diminished ability to write new business. The report also stated that the current market value of uninsured Puerto Rico bonds suggests losses of this magnitude are at least possible. The same would apply to [Assured] if it sustained losses were to exceed $1 billion, Barclays added.

Moody's Investors Service currently rates Assured Guaranty Municipal Corp. A2 with a stable outlook, Assured Guaranty Corp. A3 with a negative outlook and National Public Finance Guarantee A3 with a negative outlook.

Moody's said in a report this month that if Puerto Rico defaults were to occur, financial guarantors could sustain meaningful insured losses.

"The absence of a clear legal framework or precedent for restructuring the commonwealth's debt, as well as the number of stakeholders involved, suggests that it may be some time before a clear picture of the potential losses to Assured and National fully emerges," the report said. "Due to the projected reduction in operating leverage resulting from significant and steady portfolio amortization expected at Assured's operating companies and at National, their ability to absorb losses, while maintaining consistent risk-adjusted capital adequacy profiles, is expected to increase over time."

Moody's said that the capital positions and ratings of Assured's subsidiaries and National probably can withstand a moderate severity default of one or two of Puerto Rico's public corporations, but a more widespread systemic default that also impairs the general obligation and related bonds of the commonwealth could have significant adverse impact on the credit profiles and ratings.

"If a default were to occur, while the bond insurers would recognize an immediate earnings loss , their cash outflow would occur over many years as insurers would control acceleration and would most likely only be obligated to make timely cash payments of interest and principal when due," Cure said. "Also, the loss gap would most likely not be 100 cents on the dollar, but some smaller amount. "

Cure said in the Detroit and Jefferson County bankruptcies, new debt issues helped limit insurers' exposure.

"It will also be interesting to see if the insurers help finance a new deal as part of a restructuring to provide Puerto Rico with liquidity and help restructure the their existing insured debt. This could also, potentially, relieve the insurer's loss, assuming the Puerto Rico can eventually improve fiscally," said Cure. "This seems to have been a strategy used by insurers in the case of Jefferson County."

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