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Op-Ed: Banks’ ‘recklessness’ cost insurers $720M

Puerto Rico bond insurers this month filed suit against eight well-known investment banks (UBS, Citi, Goldman Sachs, J.P. Morgan Securities, Morgan Stanley, Merrill Lynch, RBC and Santander) for failing to perform proper diligence on Commonwealth bonds worth approximately $11 billion.

The train of neglect ran from 2001 to 2015 and included revenue and expenditure falsification and misleading debt gimmicks. In short, the suit alleges that the official statements promoted by the banks were fraudulent.

The lawsuit by MBIA Insurance Corp. and its National Public Finance Guarantee Corp. unit reveals the fatal flaws and conflicts of interest that plague the $8.3 billion Puerto Rico Electric Power Authority debt restructuring deal that is currently before the bankruptcy court.

The complaint contends that the insurers were victims of the banks’ recklessness. The banks looked the other way as Puerto Rico’s economy declined. They peddled bonds to insurers as sound investments that could be reasonably insured against default. The level of deception was motivated, according to the complaint, by a drive for lucrative fees by the banks as they cynically cast aside bedrock principles of care and concern for the insurers or the people of the Commonwealth.

The ensuing defaults have had tragic consequences for Puerto Rico and its residents, as well as costing the insurers $720 million. The insurers are now seeking damages. If the case is allowed to proceed, its findings regarding the legality of various Commonwealth debt issuances could be more valuable to the people of Puerto Rico than any awards eventually paid by the banks to the bond insurers.

The lawsuit specifically cites eight bond issuances by PREPA totaling $3.7 billion. In addition, in another recently filed action to obtain relief from fraudulent oil purchases, the Puerto Rico Financial Oversight and Management Board (FOMB) made a financial disclosure in which it stated that PREPA was insolvent in 2011, calling into question another $1.3 billion of PREPA debt issued after that time

The pending PREPA debt restructuring agreement (RSA) before the bankruptcy court covers $8.26 billion of debt, of which the legality of $5 billion now appears questionable. The Commonwealth, former Gov. Ricardo Rosselló and the FOMB have all endorsed the deal which would saddle PREPA ratepayers with paying somewhere between 67% and 75% of this debt back to bondholders. In other words, Puerto Rico’s fiscal leaders expect consumers and businesses to pay back between $3.35 billion and $3.75 billion in debt that may have been issued illegally.

State and local governments across the United States facing pension solvency challenges are at the early stages of exploring various means of leveraging assets —primarily through transfer, lease or sale — for the purpose of shoring up underfunded retiree benefit systems.

Why is the FOMB agreeing to the repayment of debt that has been called into question? Perhaps because its chief financial advisor on PREPA restructuring, Citi, is a financial advisor to the FOMB. Citi is named in the lawsuit with the bond insurers as an offending bank, and now continues to secure lucrative fees through advising the FOMB. For Citi to advise the FOMB that some of the debt was questionable, would be to admit that the bank’s past due diligence was deficient.

The debt deal also suffers from several other fatal flaws, including: (1) the lack of a clean set of books for PREPA that can serve as a reliable depiction of its actual financial condition, given the FOMB investigation of PREPA’s auditing firm BDO, whose managing partner in Puerto Rico was recently arrested for fraud; (2) the fact that the deal was negotiated on behalf of the Puerto Rican government by Christian Sobrino, who lost his job amidst the recent scandals that led to the collapse of the Rosselló administration; (3) the economic reality that the terms of the deal are unaffordable and will result in debt service costs that will rise faster than the projected growth of Puerto Rico’s economy; and (4) the lack of true-up mechanism in the deal that could result in it being un-ratable or not receiving an investment grade rating.

Several immediate and medium-term steps are required. The Commonwealth and FOMB need to rescind their support for the debt deal and cancel it. The FOMB must step up efforts to determine the level of valid debt actually owed by PREPA, and the new Governor or legislature should reinstate the Commission for the Comprehensive Audit of the Public Credit.

The FOMB needs to make public the results of its investigation of the BDO affair, especially given Puerto Rico’s history of suppressing past investigations related to the PREPA oil purchasing scandal, and the Whitefish and Cobra contracts.

Tom Sanzillo (tsanzillo@ieefa.org) is IEEFA’s director of finance.

The Commonwealth and FOMB need to more rigorously oversee the sizable army of financial advisors, law firms, accountants, credit agencies, underwriters and consultants that are fraught with conflicts of interest.

And, an Independent Private Sector Inspector General must be set up for PREPA to pro-actively monitor its internal operations and ensure that the rebuilding process is not a repeat of the incompetence and corruption that have plagued the Island’s governmental structure up until present.

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