Puerto Rico's battle-hardened banks continue to face an uphill climb with a big borrower and never-ending woes in the fiscally challenged territory.

Banks on the island are getting pinched on several fronts. Several institutions participated in a $550 million fuel purchase line of credit to the Puerto Rico Electric Power Authority, or PREPA. Repayment is in doubt as PREPA struggles with debt and a need for improved infrastructure, even though at least one creditor believes the entity has the means to make payments.

PREPA's woes highlight an even greater concern — the island's enormous socioeconomic pressure.

Puerto Rico's government, weighed down by more than $70 billion in debt, is searching for ways to cut costs and increase revenue. Unemployment is high and the population is declining. The result is an unenviable climate for the handful of banks that emerged from the financial crisis and its aftermath.

"Their fate is tied to a very large degree on how the island is doing," said Fernando Margarit, a lawyer at Hunton & Williams. "But these banks have managed to survive."

The Puerto Rican government and PREPA, a public corporation that provides electricity to the territory, are dealing with vast amounts of debt, but neither entity can file for bankruptcy. (A law that would have allowed public corporations, such as PREPA, to restructure debt was struck down by a federal court judge earlier this year.)

What's missing is a clear path to resolve longstanding issues, which creates extra uncertainty.

"There's no ax hanging over people's heads" without the potential for bankruptcy, said Sharon Levine, vice chair of the bankruptcy, financial reorganization and creditors' rights department at Lowenstein Sandler.

PREPA, which is restructuring itself under a forbearance agreement with lenders, has $9 billion in debt, including a roughly $550 million participation shared by several Puerto Rican banks. The loan participation has been in forbearance since August, and the banks are preparing to take a haircut on the credit. Still, the banks will likely fare better than other creditors because of the loan's senior position, industry experts said.

OFG Bancorp in San Juan said in April that it would record a $24 million loan-loss provision after it moved its $200 million participation in the loan to nonaccrual status.

The Puerto Rican unit of the Bank of Nova Scotia, the participation's lead manager, has a $200 million exposure, but management hasn't disclosed how it has classified the loan, Keefe, Bruyette & Woods said in a recent note to clients.

First BanCorp and Popular Inc., both based in San Juan, are each owed $75 million under the line of credit, KBW said in its research note.

The loan "is almost like a technical default" since it is already in forbearance, said Brian Klock, a KBW analyst. "The stocks have already reacted to the fact that it is a technical default. If you talk to every one of the banks, they feel like they will get paid back, but right now this is tied up in the restructuring."

The $7.4 billion-asset OFG declined to comment for this story, though management said during a conference call last month that PREPA is able — but unwilling — to make payments. (OFG inherited the loan following its 2012 purchase of Banco Bilbao Vizcaya Argentaria's Puerto Rico operations.)

"Our credit analysis showed PREPA has the financial capability to pay its creditors," Jose Rafael Fernandez, OFG's president and chief executive, said during the April 24 call. "We also saw that PREPA's cash flows were improving or are improving."

PREPA did not respond to a request for comment.

As the banks deal with PREPA's credit, management at those institutions needs to be aware of possible public backlash, industry observers said. There is usually a political element to restructuring public entities, Levine said.

There is "definitely a feeling that they should do their part and take a haircut," Margarit said. "Puerto Rico is very small and they're all in this together."

The PREPA loan is getting the most attention from investors based on a belief that the island's banks have little direct exposure to government debt. Banks may work with local municipalities through revenue-anticipation notes — where a local government borrows from a bank and then repays it with tax revenue, industry experts said. But that seems less troublesome.

Rather, the more pressing problem is the overall economy since a bank's market can largely determine its fate. The government's financials have deteriorated "more than we have seen in other municipalities or territories before," said Arturo Porzecanski, an economist and director of the international economic relations program at American University

"There has been a huge decline in GDP, jobs and population," Porzecanski added. "The taxable base has shrunk and you can't really counter that. It's a big problem."

Puerto Rico's unemployment rate hovers over 11% and its population has shrunk by roughly 7% over the last decade. The territory's government is looking to temporarily increase the sales tax from 7% to 11.5% to increase revenue.

Richard Carrion, Popular's chairman and chief executive, said during the $32.6 billion-asset company's first-quarter earnings call that it was prepared to deal with the indirect fallout if the Puerto Rican government defaults on its obligations. That was "part of the scenarios we've looked at in our stress tests," he said.

Four Puerto Rican banks have failed since 2010, including Doral Bank earlier this year. Despite these challenges, survivors have managed to make improvements to their balance sheets and produce profit "without organic growth in their home market," said Taylor Brodarick, an analyst at Guggenheim Securities.

"I have to tip my hat to them," Brodarick said. "It is very difficult if you don't have natural growth. They're learning to manage that and produce profitability."

Macroeconomic conditions are "keeping investors away," Klock said. "There is some value there once that clears up."

Puerto Rican banks have built up capital levels and strengthened their balance sheets, industry experts said. They are busy trying to control credit costs and working with distressed borrowers. Consolidation, including expansion beyond the island, is another key consideration.

First BanCorp is aware that Puerto Rico continues to face economic challenges, but "has shown the ability the capability and potential to grow and withstand the headwinds," Aurelio Aleman-Bermudez, the $12.4 billion-asset company's president and chief executive, said in a statement sent to American Banker. He said the company has been bringing in core deposits, excluding the recent benefit of buying 10 Doral branches.

First BanCorp's top priority remains "asset quality," Aleman said. "It is our firm belief that our improved core metrics and growing capital base will allow us to continue improving our risk profile and strengthening our market position."

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.