Bond insurers are poised to withstand the possible fallout from ratings downgrades or defaults on the industry's $16 billion of Puerto Rico bond exposure.
Financial guarantors such as Assured Guaranty and National Public Finance Guarantee would be braced by their strong capital positions and the lengthy payment schedules of Puerto Rican bonds in the event of a default there, rating agencies and analysts said.
"Based on our analysis, the legacy bond insurers have sufficient capital cushion in their capital adequacy ratios to absorb higher theoretical losses due to increased capital charges or actual losses paid," Standard & Poor's said in a report Monday. The rating service added that they do not expect rating actions as a result of rating migration or defaults within the insurers' portfolios.
Total net par outstanding exposure to Puerto Rico bonds by Assured, MBIA's National, Ambac Assurance Corp., Syncora Guarantee and Financial Guarantee Insurance Corp was $15.7 billion by June 30, according to an analysis by the Bond Buyer. With exposure to a range of bonds, from general obligations to below investment-grade aqueduct and sewer bonds, insurers would be on the front lines if a shrinking economy in the U.S. territory inhibited government entities there from meeting their obligations.
"Although the bond insurers' aggregate exposure to Puerto Rico and Detroit may be large relative to current statutory capital, any claim payments resulting from actual losses are made based on the payment schedule of the underlying issue with no acceleration," S&P said.
Puerto Rico's economy shrank in July and August by 1% and 0.4%, respectively, according to the island's Economic Activity Index. The economic measurement has been declining since November 2012. Yields on Puerto Rico Sales Tax Financing Corporation, or COFINA, bonds have risen to more than 8%, while the commonwealth's public improvement bonds have traded at yields higher than 9%.
"The mitigants which Standard & Poor's pointed out are often overlooked by those who focus on the insurers' total exposure figures without context or any appreciation of the way bond insurance works," Mark Palmer, an analyst at BTIG Research, said in an interview.
Standard & Poor's generally rates Assured's and MBIA's exposures as BBB, meaning a one-category decline in ratings would bring the exposure to BB. Such a downgrade would result in incremental capital charge increases of $65 million for each insurer, S&P said in its report. If credit fundamentals deteriorated to 'B,' S&P said, the associated increase would be approximately $115 million.
Assured had a capital adequacy cushion of between $450 and $500 million according to S&P's year-end 2012 analysis, the rating agency said. National's cushion was between $350 and $400 million.
"Even in the unlikely event of a default by Puerto Rico, there is no reason to believe that the bond insurers would have to pay out $17 billion," Dick Larkin, senior credit analyst at HJ Sims, said in an email. "No one in their right mind believes that the bond insurers would have to come up and pay all $17 billion. To assume that PR would pay nothing on its debt would just be plain stupid."
Puerto Rico officials said on an investor call Tuesday afternoon that the territory will do whatever it takes to honor its commitments. On Monday the island reported first quarter revenues were up 5.4% from the previous year, or 0.6% above projections.
"That willingness, as well as a plan for addressing the challenges it faces, distinguishes Puerto Rico from other municipal and sovereign situations to which it has been inappropriately compared," Palmer said. "While Puerto Rico's absolute amount of debt is daunting, its debt maturities during the next few years are well laddered and not overly imposing."
Moody's Investors Service downgraded COFINA's bonds to A2 from Aa3 on Oct. 3. MBIA's National has $684 million of exposure to COFINA bonds, while Ambac reported $805 million of exposure to the sales tax-backed bonds, some of the territory's highest-rated debt.
"Puerto Rico's government has indicated that it is committed to honoring its obligations to bondholders and has demonstrated its commitment by the responsible and proactive actions it has taken to address its significant economic challenges," Adam Bergonzi, National's chief risk officer said in an emailed statement. "We are continuing to monitor the situation closely, but we do not expect a default by Puerto Rico."
Ninety-two percent of Assured Guaranty's exposure to Puerto Rico is rated investment grade internally and by both Moody's and S&P, the company said in a statement on its website Friday.
Many analysts are unjustly dismissing the risk of Puerto Rico bonds on insurers, said Matt Fabian, managing director at Municipal Market Advisors. While insurers may not cover acceleration or annual claims, the perception of Puerto Rico bonds weighing on an insurer's books could damage its ability to operate, Fabian said.
"Because it's impossible to predict just how bad Puerto Rico exposure could be, you don't know the steps the monolines' overseers might take," Fabian said in an interview. "Any inclination that regulators might step in could do damage to the insurers' ability to write new business, it could break market opinion."
If Puerto Rico is unable to navigate its way out of financial turmoil, the cost to insurers could be more than analysts expect, resulting in rating agencies taking preemptive action on insurers, Fabian said. In a worst case scenario, regulators would want to halt the outflow of cash to make sure other policyholders are protected, as they did after the financial crisis when insurers such as Financial Guaranty Insurance Co. were forced to restructure.
Taylor Riggs contributed to this story.