The shame of leaving Puerto Rico in limbo
Puerto Rico’s Government Development Bank (GDB) last week skipped a $422 million payment to bondholders, bringing Puerto Rico’s total bond defaults in 2016 up to $5 billion. The move was widely expected, with those GDB bonds trading at 20 cents on the dollar, but it still represents a significant escalation in the commonwealth’s long-running debt crisis. Puerto Rico’s downward spiral conceivably began in 2006 when U.S. government phased out tax credits for manufacturing investment, pushing the island’s economy into recession. But the crisis has really been brewing for decades because of the triple-exempt status of Puerto Rican bonds (meaning bondholders do not have to pay local, state or federal taxes on income derived from the bonds. The only other triple-tax exemption occurs if an investor buys bonds in the state in which he or she lives).
The triple-tax exemption made Puerto Rican bonds attractive to American mutual funds, causing institutions to gorge themselves on the island’s debt. In turn, the massive amounts of capital raised by the Puerto Rican government was largely squandered in ways that didn’t bring the economic growth necessary to sustain a massive debt load. As the government has been forced to use a greater percentage of its budget to service debts, quality of life for Puerto Ricans has deteriorated. Today, 45% of the country lives in poverty. The diminished quality of life has led to a mass emigration of Puerto Ricans to the mainland United States, which has done further harm to the island’s economy, causing borrowing costs for the government to rise. Rinse, repeat. Death spiral.
For almost two years rating agencies and Puerto Rico’s governor have been warning this day would come when Puerto Rico would be unable to pay its debts and urging Congress to come up with a restructuring plan. At the same time, Puerto Rico’s misfortunes caused its bonds to trade at a discount to par, attracting hedge funds specializing in distressed debt. These hedge funds counted on the extensive legal protections afforded Puerto Rican bondholders, especially for those owning first-priority General Obligation (GO) debt.
As was the case with Argentina, many of Puerto Rico’s bonds were sold under New York jurisdiction. When Argentina defaulted on its sovereign bonds in 2001, a New York judge barred the government from accessing global credit markets until it reached a settlement with all creditors. Argentina finally reached a settlement earlier this year with the final holdout creditors, a group of hedge funds, after a messy 15-year battle coinciding with deep economic turmoil. Officials, including Treasury Secretary Jack Lew, are worried about the effect of a similarly protracted battle over Puerto Rico’s debt.
“As we saw in Argentina, holdouts can drive a process to the brink,” Lew told the Wall Street Journal last week. “Puerto Rico doesn’t have 15 years. If this goes into litigation…there won’t be anything left of Puerto Rico.”
As a commonwealth, Puerto Rico also finds itself in limbo. It’s not a municipality, so its agencies don’t have the Chapter 9 bankruptcy protections like Detroit. It’s not a sovereign country, so it has fewer tools for escaping economic hell than a sovereign nation like Argentina. Sovereigns have the ability to hit the reset button by devaluing their currencies, and thus the real value of their debts, as well as appeal to global bodies like the International Monetary Fund (IMF). Puerto Rico has no such options. New Argentine President Mauricio Macri campaigned on a promise to remove the peso’s peg to the dollar days after taking office, and he followed through on that promise in December, causing the currency to immediately drop by around 30%.
Holdout creditors have attempted to paint actions taken by the current Puerto Rican government as similar to the intransigence of the Kirchner administration in Argentina, but in reality the situations are entirely different. Not only does Puerto Rico not have the same policy options as Argentina, its economy and ability to service its debts are in much worse shape.
Puerto Rico, with a population of 3.5 million, has a total of $72 billion in debt spread across 17 government entities. Only New York, with a robust economy and population of around 20 million, and California, with nearly 40 million residents, are more indebted. Puerto Rico’s debt-to-GNP ratio grew to 100% last year, high even for a large country with a central bank able to print currency. For all U.S. states, the average debt-to-personal income ratio is around 4%, the highest being Hawaii at 10%. In Puerto Rico it’s greater than 90%.
Puerto Rico is like a migrant worker in Dubai: lured reluctantly into a suspect arrangement, passport taken away, drowned with debt and held hostage to repay with money it doesn’t earn.
Clearly a restructuring plan is needed for Puerto Rico’s debt, but such an agreement is at the mercy of a dysfunctional U.S. political system. As more hedge funds have gotten involved in Puerto Rican debt, so has the amount of anonymous lobbying money increased pushing the narrative that a restructuring would constitute a bailout — a dirty word after the 2008 financial crisis — even though current proposals include no taxpayer money (although maybe they should).
The Center for Individual Freedom, an Alexandria, VA-based non-profit that doesn’t have to disclose its donors, spent more than $2.5 million through mid-April on anti-restructuring television and radio ads. Congressional Republicans have vehemently opposed a restructuring plan, forcing the Governor to issue a moratorium on all debt payments in order to maintain essential government services. Unless a comprehensive bill is passed by Congress, bondholders are now likely to turn to courts to block the Puerto Rican government from operating until it pays up.
The more important deadline for Puerto Rican creditors, and thus Congress to get a bill passed, is July 1, when a $805 million payment on GO bonds is due. Trading at 65 cents on the dollar, Puerto Rican GO bonds due in 2035 are pricing in a reasonable likelihood of default. A failure by Puerto Rico to make that GO bond payment would constitute the first default for a state-level borrower since Arkansas in 1933. It would likely trigger a restructuring of $13 billion in GO bonds, the largest-ever in a tax-exempt market. The “smart money,” including this week’s “Wall Street Week” guest Jeff Gundlach, were still buying impaired Puerto Rican GO bonds as recently as last November. Yes, GO bonds have deep legal protections, but those protections are moot if there is simply not money to repay creditors.
The island’s pension obligations are largely an after-thought as the government tries to keep the lights on, but they are in the most dire straits of all. Puerto Rican pension funds have less than 1% of assets needed to pay all promised benefits. They are short $30 billion, on the hook for $2 billion this year (which constitutes 25% of general-fund revenue) and poised to go completely broke in only five years.
Because there are 17 different government entities (with varying credit protection) in debt distress, a one-size-fits-all settlement is challenging and any litigation would be extremely complex. Not only would creditors be suing Puerto Rico for repayment of debt obligations, but they would likely sue each other in a fight over credit priority.
The Puerto Rican debt crisis has been mischaracterized as only a hedge fund issue, but it has also blindsided mom and pop investors unwittingly invested in municipal bond funds. Oppenheimer has been under particular scrutiny by regulators for adding to its already overweight position in Puerto Rican bonds as the bonds’ value has eroded. Oppenheimer makes up the top 14, and 17 of the top 20, funds ranked by allocations to Puerto Rican bonds. One of its flagship funds, as of March 31, had a 45% weighting in Puerto Rican bonds.
The U.S. House of Representatives has ostensibly been working on a Puerto Rico bill that would establish a federal oversight board to manage the restructuring and spending plans. Congress has from May 10, when it returns from recess, until July 1 to pass a bill before the crisis takes an even more grave turn. Unless a bill is passed, a federal bailout may be the only solution according to Treasury Secretary Lew. House Speaker Paul Ryan, a principled and compassionate conservative, has been forced into a difficult position over Puerto Rico. He recognizes the pressing need to address the Puerto Rican crisis, but most of the opposition for a restructuring deal comes from within his own party — which, if you haven’t heard, is in the midst of a Donald Trump-induced civil war. Ryan may find himself in a position where he can only pass a bill alongside his Democratic colleagues, a politically risky move in politically volatile times.
How much of a haircut is needed to create a sustainable solution? Bank of America Merrill Lynch wrote last September: “If, in the unlikely event, debt service on all securities is paid with the same priority, debt service payments on each security would have to be cut roughly 77% over the next five years. Even if all of the available funds for debt service are dedicated to GO and GO-guaranteed debt service, debt service would have to be cut 45%.”
While any deal will certainly need to include debt haircuts and government spending cuts overseen by a control board, we should learn from the post-financial crisis recovery that pro-growth structural reforms are more effective than austerity. A Puerto Rican economic resurgence is in the best interests of all parties. The commonwealth’s tax code should be overhauled to become more friendly to economic development. Social welfare programs should be dramatically reduced and labor laws softened. Public-private partnerships should be pursued to make essential government services, like the Puerto Rican Power Authority (PREPA), more efficient. Ultimately, we must also either allow Puerto Rico to operate as a sovereign country or afford them legal protections more similar to American states (which is the preference of the Puerto Rican people).
As it was the case in the financial crisis, Puerto Rico’s current plight represents a failure on multiple levels: U.S. mutual funds’ insatiable desire for Puerto Rico’s triple-exempt bonds, the U.S. lawmakers’ mishandling of Puerto Rico’s commonwealth status and the Puerto Rican government’s misappropriation of funds. But like we did after 2008, we must now reckon with our failures and take pragmatic steps to create a better future.
