Yesterday was a significant day for our portfolios’ because there was a lot of news about Puerto Rico, which impacts our positions in AGO, MBI and Ambac Financial Group. Firstly, Puerto Rico paid all of its $355MM due on its notes issued by the Government Development Bank. Most of these bonds were backed by the General Obligation of the Commonwealth, which have the highest constitutional protections, so a default would have led to immediate litigation. In addition, Puerto Rico and creditors pleaded their cases in front of Congress, as Puerto Rico wants access to Chapter 9 bankruptcy laws, which are not available to States or U.S. territories such as the Commonwealth. I watched all 2 and a half hours of footage. The Obama administration and Treasury Secretary Jack Lew have already made clear that they want Puerto Rico to have access to Chapter 9, despite the fact that the Puerto Rican constitution explicitly prohibits it and puts debt service above all other payments. Watching the debate one thing was clear. Puerto Rico is in a bad situation that is self-inflicted due to terrible governance. They can’t even put together a budget or a balance sheet. They say they have no money and are going to have to claw-back from other revenue sources to pay the general obligation debt, yet they can’t provide a balance sheet to prove that. Debt service is about 16% of total revenues. While high it is a manageable number and there are way more areas where cost cuts must be made. How you plea before Congress for money without a balance sheet is absolutely beyond me. I believe it will be very tough for Congress to pass any approval on Chapter 9 anytime soon but either way, it doesn’t change our investment thesis.
The next big date is January 1st, when $945MM of total bond payments are due, including $363MM in general obligation debt service. Puerto Rico wants access to Chapter 9 because it will pressure the creditors to settle for the biggest amount of a haircut possible on the debt. If they can’t obtain that, the best solution is clearly a negotiated settlement. One is already close to being accomplished on $8 billion of debt issued by PREPA, which is the electric utility that would only result in about a 15% haircut for creditors and even less for the bond insurers, despite some expectations that it would be 50%. The debt payment on January 1st is most of the bond insurers’ exposure for all of 2016, so it would be huge if they make it and the stocks would probably rally. I believe it is in Puerto Rico’s best interests to make the payment. This would give Congress more time to make a decision on the Chapter 9 and would allow more time for negotiations with creditors. A default on the general obligation bonds would bring about a downpour of litigation. Creditors will be willing to negotiate in good faith but Puerto Rico also needs to take the necessary steps such as providing financial statements and cost cuts on its side.
Regardless of what happens in January, AGO and the other companies are some of the best opportunities I’ve ever found in the market. Nothing is guaranteed, but in my opinion there is no doubt we are right and will be successful. The only question is timing. Like I’ve said before, if AGO was under-reserved by $1 billion, which I highly doubt and has not happened before even during the Financial Crisis, the impact would only be about $5 off of the adjusted book value of $60 per share. Total net par exposure to Puerto Rico is about $5 billion for AGO or under $9 billion in debt service, paid out over the next 30 years. AGO generates over $400MM in investment income each year and has already been reserving. I am exceptionally confident that we are going to make a great deal of money on these investments. Obviously, we have a lot of exposure to options coming due between now and mid-January. These options will either expire worthless, generating solid profits, or we will end up owning more AGO stock at an even deeper discount. Either way we are happy. We just need to realize that this investment is going to fluctuate based on news headlines but the underlying facts remains the same and won’t change by any major degree. As long as we are patient, we should make a fortune. That is much more than I can say about 99% of the other investments that I’ve looked at, particularly in the stocks of companies like Amazon and Facebook which are stratospherically priced and have been leading the market higher, as most stocks are negative this year. January 1st is a big day, options expiration is a big day, and I expect that most of the Puerto Rican credits will be resolved by mid-year 2016, which should lead the stock with a clear path higher. My advice, relax and enjoy the holidays. We’ve got great positions and I think we are set up nicely for 2016! As always, if you have any questions, don’t hesitate to contact me at 805-886-8140.