Finance

Highlights - January to June 2010

• Fitch Ratings assigned a rating of BBB+ to the Puerto Rico Electric Authority's (PREPA) $350 million issue of power revenue bonds, series YY (issuer subsidy Build America Bonds) and $275 million of power revenue refunding bonds, series ZZ. Fitch also affirmed the BBB+ rating on PREPA's outstanding power revenue bonds. The outlook is stable as of March 2010.
• On May 2010, three banks operating under cease and desist orders were seized by the federal regulator and acquired by other local banks in Puerto Rico. The local banks that acquired the troubled banking institutions were:
• Banco Popular de Puerto Rico (BPPR) acquired Westernbank, which had $5.7 billion in assets (3rd largest in PR), an $8.1 billion loan portfolio, $8.4 billion in deposits and 46 branches. This acquisition made BPPR the largest bank in the island with 37% of the market share of total commercial bank's assets.
• Scotiabank of Puerto Rico acquired R-G Premier Bank, which had $10.8 billion in assets (7th largest in PR), a $5.1 billion loan portfolio, $4.2 billion in deposits and 29 branches. At the time of the acquisition Scotiabank was smaller (10th largest) than the bank acquired. This acquisition made Scotiabank the 4th largest bank in the island with 9.7% of the market share of total commercial bank's assets.
• Oriental Bank and Trust acquired Eurobank, which had $2 billion in assets (9th largest in PR), a $1.5 billion loan portfolio, $1.9 billion in deposits and 25 branches. This acquisition made Oriental Bank the 5th largest bank in the island (previously 6th) with 9.6% of the market share of total commercial bank's assets.
• The Fortuño administration established incentives for the purchase of new homes using a second mortgage and a grant to help buyers pay closing costs; As of May 31, 2010 the Housing Finance Authority (HFA) has approved 1,466 second mortgages for $21.5 million, propitiating $234 million in sales. Some $30 million was earmarked for this second-mortgage program, of which $8.5 million is still available. The closing costs incentives, or second mortgages, were extended to September 30, 2010.
• Citibank expands its IBE operations in Puerto Rico although it ceased retail-banking and broker-dealer operations in Puerto Rico in 2007. Parent company Citigroup (Citi) still maintains a strong local presence with four business divisions, a workforce of more than 1,000 employees and an asset base of $3 billion. The IBE in Puerto Rico is the operational and trading arm for Citi's Latin American wealth management private bank, serving customers all over the Latin American region including México, Central and South America and the Caribbean.

The Puerto Rican financial sector operates similar to the one of an US state. In Puerto Rico there is no Central Bank and it is the US Federal Reserve Bank which acts as a Central Bank, determining the receivable interest over loans and regulating Monetary and Credit policies. As a part of the US Federal Banking system, Puerto Rico adheres to all U.S. international financial regulations. The banking institutions in Puerto Rico are insured and regulated by the Federal Deposit Insurance Corporation (FDIC) which insures deposits for up to $100,000. The local financial regulatory entity, The Office of the Commissioner of Financial Institutions (OCIF), works closely with the FDIC and other federal regulatory agencies. Commercial banks capture the biggest role in the financial sector of Puerto Rico, with 48% of all financial assets in Puerto Rico, which equals to approximately $83 billion dollars in 2009 (excluding the international commercial banking). Other components of the financial sector include International Banking Entities (IBE), Investment Companies and Government Banks, as described and segregated in the table and graph below.

Commercial Banks

As of 2010 there are nine commercial banks on the island, and three are international institutions: Scotiabank, Santander and BBVA. Puerto Rico's oldest (established in 1893 in Puerto Rico) and largest bank, Banco Popular de Puerto Rico, still leads the industry in commercial and individual lending, and private banking business. Banco Popular has expanded outside of Puerto Rico with branches in many US states such as Florida, California, Texas and New York. Also, in May 2010 Banco Popular made its operations even larger in the island by acquiring Westernbank of Puerto Rico, a bank that had a high amount of bank deposits and a large commercial loan portfolio. This acquisition gave Banco Popular 42% of all bank deposits in the island and 38% of all loans, by far the highest market share of all the banking institutions in Puerto Rico. Other top local financial institutions in Puerto Rico include Firstbank of Puerto Rico, Doral Bank, Scotiabank of Puerto Rico, Oriental Bank and Trust and Banco Santander Puerto Rico. Due to FDIC regulations and extraordinary bank loses in 2009 two other financial institution were sold in May 2010, Eurobank and R-G Premier Bank. R-G Bank was acquired by Scotiabank of PR and Oriental Bank and Trust acquired Eurobank, making their previously small commercial bank operation large and significant in Puerto Rico.

Total assets in commercial banks of Puerto Rico have decreased overall since 2007. This decreasing tendency is true for almost all assets in commercial banks, especially deposits and loans.

In addition to decreasing assets in commercial banks, net income amounts have also decreased and had negative growth since 2005, reaching a negative net income amount for the first time in 2009. This aggregate negative net income amount for 2009 was one of the main factors three financial institutions in Puerto Rico had to merge their operation with three other local banks in May 2010.

In addition to private commercial banks in the island, the commonwealth of Puerto Rico operates two commercial banking institutions, The Government Development bank, which is the Commonwealth's fiscal agent, and The Economic Development Bank for Puerto Rico, which provides financing for small businesses and first time entrepreneurs. These banks are treated separately due to their specialized public help nature.

Financial Performance

The total financial sector has contracted 5% over the past 5 years, and 10% in the past year. Brokerage companies, government banks and credit unions are the only financial sectors that have shown a positive growth in the past five years. Brokerage Companies have been growing at an average rate of 26% per year; which is the highest growth rate by a financial sector in Puerto Rico. The highest negative growths in the financial sector were suffered by international banking entities (-32%), then small loan companies (-30%), followed by leasing companies (-12%). Mortgage loan companies had the highest recent (from 2008 to 2009) negative growth of 18%, which was caused by the recent real estate economic crisis in Puerto Rico.

This past year, the growth of brokerage companies has compensated for the recent negative growth in the mortgage loan industry. Puerto Rico's largest investment and brokerage's companies include UBS Financial Services, with more than 50% of the market share, followed by Santander Securities and Popular Securities, each with about 16% share of the market in this financial sector.

Consumer Debt

In Puerto Rico debt of consumers is slowly declining due to the recent problems faced by the commercial banking sector, which represents 30% of the total debt of consumers. This past year (from 2008 to 2009) the debt of consumers declined 1%, primarily attributed to commercial banks and loan companies. More than 77% of consumer's debt is created in 3 types of institutions: Commercial Banks, Installment Sale Companies and Local Credit Unions.

In this recent lending "crisis" student loans have grown the most in Puerto Rico. Following student loans, this past year debt provided by PR employee's association and credit cards has also grown significantly. The only two sectors that had negative growth this past year were commercial banks and small personal loans. Overall lending activity keeps increasing in every sector but commercial banks; this is a problem since more than 30% of consumer's debt originates from this sector. As a whole the lending sector will continue to suffer if the production in commercial banks does not increase in Puerto Rico.

Mortgage Sector

The loan sector in commercial banks has been affected by the overall economic situation of the island and US financial sectors. Puerto Rico's economy is very dependent on the United States economy, which means that currently Puerto Rico is in a financial recession, similar to the US. Bank operations in the island have remained stable, but this past year total loan originations in the island have gone down 5%. Indirectly, the economic crisis has made itself present on banks. One of the indirect impacts on banks has been the restrictions for generating secondary mortgages or mortgages for second homes. Currently, the secondary mortgage market has been limited due to the considered high risk factor, the low liquidity of local banks, and the high number of foreclosed properties in some real estate portfolios. Also, requirements to acquire a regular conventional loan on a first property have gone up, making it twice as hard to obtain a loan today. These tough restrictions have also hindered the loan production rates in the island. As per their distribution, twenty-eight percent (28%) of the value of all loans in Puerto Rico are given as residential property loans, making this type of loan the biggest in Puerto Rico. Other primary loans include loans secured by non-residential real estate (24%), commercial, agricultural & industrial loans (21%), loans for construction and land development (11%), and other miscellaneous loans (10%).

For the past five years loans in the classification of "Land Development and Construction loans", "loans secured by non-residential real estate" and "Family Residential Property Loans" have grown around 5% per year. These 3 types of loans are the only loans with positive historic growth; the remainder 5 types of loans have had negative growth for the past five years. Overall, the total lending activity for the past year decreased 5%, but historically total lending activity sill has a positive growth of around 3% every year for the past 5 years.

Another factor that has influenced the financial sector is the continuous flattening of the yield curve, with short-term interest rates higher than the long-term rates. This has a negative impact on profits and a particularly significant impact on banks with greater dependences on brokered deposits. As a result, local banks experienced a significant drop in fixed interest profits and market capitalization, which has fallen close to $20 billion since 2005. These significant drops have generated banking conditions for consolidations that are currently occurring or will occur in the near future.

Prime Rates and Discount Rates dropped significantly from 2002 to 2003. These same rates increased to a maximum of 8.25% from 2006 to 2007. Currently, discount and prime rates are dropping at a fast rate due to a US governmental economic stimulus plan set in 2009. The Federal Reserve cut interest rates at a fast pace in 2008 in order to encourage people to invest and to help economic growth, but the incentive did not work. These current (2010) decline in rates continues to be the biggest drop since 2001, when terrorist attacks and a recession threatened the US economy. The current decline in interest rates applies to every state and commonwealth, including Puerto Rico. With current marginal improvements in the performance of the US economy, we can assume that the Fed will set in motion interest rate increases by the end of the third trimester in 2009. Since Puerto Rico's interest rates and economy are consequent of the mainland's changes, the variation in interest, discount and prime rates for Puerto Rico will be the same as in the US and defined by the US Fed. As of January 2010, prime rates and mortgage yields are at a record of 3.25% and 4.80%.

Mortgage Institutions

Mortgage institutions have been declining due to the current economic situation and the strong competition of commercial banks. An approved governmental incentive program for the sale of unsold inventory units was successful in moving inventory, and by June 2008 some 2,500 units were sold due to this incentive. Even with this incentive, the 2009 residential sales of new homes was below the levels of the last four years sales, creating a slight saturation of housing in some areas of Puerto Rico.

Currently the Puerto Rican population is still hesitant of purchasing new homes and creating new mortgages. Incentives such as government credits, low interests, and falling real estate prices are still falling short and are not sufficient to compensate for a high-risk real estate investment market. Mortgage institutions had their peak in assets in 2004. After 2004, the assets for the mortgage company's sub-sector decreased severely, to almost half of what they were in 2004. Small loan companies are also decreasing and the only sub-sector that is mildly increasing are brokerage firms. This past year Brokerage firms have increased drastically, almost comparing to the sub-sector of mortgage institutions. Other factors that have affected the industry of mortgage institutions are the regulatory issues that affected key players in the banking industry and the restrictions generated in the secondary mortgage markets.

Small Loan Companies

The small loan companies (SLC's), locally known as "Financieras", have traditionally offered financing to individuals with a low credit profile, which made them very unattractive to larger banks. The SLC's offer loans with very flexible payment plans, at a high cost, in view of the high-risk profiles of the clients that request the loans. A number of the local banks started to consider this market creating their own small loans divisions and absorbing some SLC business from 2004 to 2007. Currently this sub-sector is disappearing due to the recent sub-prime loans given by these companies. The sub-prime loan problem that was being suffered in the United States was only suffered in Puerto Rico by the SLC's, the only companies offering such loans. This market has experienced negative growth for the past 8 years, and this past year had the largest negative growth (-16%) of all the sub-sectors in the financial sector.

Credit Unions

The credit unions or savings and loans cooperatives have been active in the island for many years. Cooperatives are a major component of Puerto Rico's financial sector even though they only represent 4% of the financial sector. After the approval of Law 255 in 2002, cooperatives are now in the position of offering most of the services and products which commercial banks offer, including personal loans, mortgage loans, commercial loans with collateral, and perhaps of greater significance, they can now lend to non-members.

Since 1999 the activity for Credit Unions has increased at a steady growth of 5% per year. On average, Credit Unions increase their assets $230 million dollars per year, having a total of $7.3 billion dollars in assets on 2010, as per the OCIF 2010 1st quarter report. This is a significant financial sector in the island, which gets number five in the rank of those with more assets, over passing the mortgage loan financial sub-sector. Although most institutions are small, consolidations in this sub-sector and the entrance of federal credit unions into the Puerto Rican market will make it a stronger competitor for commercial banks in the near future. Assets in Credit unions are evenly distributed since the highest market share by one institution is 6.7%. The market of Credit Unions in Puerto Rico is composed by 119 institutions and they mainly cater the financial needs of the population outside the metropolitan area, were commercial banks are not as accessible.

Credit Unions only compose 4% of the entire financial sector in Puerto Rico, but its constant growth since 2006 shows a promising future to this financial sector. Credit Unions are one of the few financial sectors with constant growth, along with brokerage firms. This past year the growths of assets and deposits for Credit Unions were the highest rates they have been in the past five years. The growth in activity for Credit Unions could be attributed to consumers preferring the stable local Credit Unions in Puerto Rico instead of commercial banks with their recent instability record.

International Bank Entities

International Banking Entities (IBE's) are mostly divisions of commercial banks that have operations that are exclusively off the island. The entities invest and lend abroad and receive funds only from external sources. They are tax except in Puerto Rico and because of this have become a very attractive entity. The local IBE's have been used by banks that are established in Puerto Rico to carry out bank acquisitions and expansions abroad. International Bank Entities rank number two as highest on assets in the financial sector, but have had a negative growth of 10% per year for the past five years, and this past year had their worst contraction of negative 30%. The recent negative growth is expected to recover after the uncertainties in the international markets, generated by the current financial crisis, are cleared. Currently International Bank Entities have $42.16 billion dollars in assets or 24% of the total financial sector in Puerto Rico.

The future of Puerto Rico's Financial Sector

Puerto Rico's financial sector is expected to keep decreasing. Factors such as future unemployment, low mortgage production due to real estate price inflation and rise in the consumer price index are the main contributors to the estimated decrease in the financial sector for Puerto Rico. The stagnant financial growth since 2006 can be better reflected with the GNP growth by decade in Puerto Rico. Usually, GNP in Puerto Rico grows from 17% to 27% every decade, this past decade (2000 to 2009) the accumulated GNP grew 1%, which reflected growth the first 5 years of the decade and a contraction of that past growth the consequent years. In comparison to the three previous decades, this past decade was basically financially an economically null. It is expected that the current decade (2010 to 2019) will be much better financially than the one just passed.

Part of the reason Puerto Rico's financial sector's have contracted is because it is closely linked to the islands'economic growth, as well as changes in the global financial situation. The local economy will not experience rapid growth in the near future. Although the financial sector, as a whole, will continue to grow at a rate above those for the economy, no stimulus will be forthcoming for macro-economic growth.

Once global financial stability is achieved, the local banking sector will benefit and grow. The global financial situation has changed drastically in recent years and is reasonable to expect that commercial banks, particularly, will remain changing and undergoing a major transformation in the medium and long terms. Puerto Rico's financial sector is closely linked to the global economy and will feel the impact of global developments. In addition, given the commonwealth's link to the United States, output in Puerto Rico is likely to grow at least in tandem with output on the mainland.

The island possesses certain fundamental advantages that create the potential for sustained growth: an increasingly skilled and educated workforce, a favorable business climate, deep familiar connections to the mainland United States, and the benefits of U.S. legal, contractual, and financial structures. The challenge for Puerto Rico going forward will be to devise an appropriate set of governmental policies and incentives to build on its strengths.