Puerto Rican Bond Default Raises Likelihood of U.S. Bailout

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Observers lately have taken to calling Puerto Rico “America’s Greece.” That might qualify as an insult – to Greece. And the American public may have to cover the debts. On Monday, the island government announced that its Public Finance Corporation was unable to make its full scheduled loan payments over the weekend. The $628,000 in disbursements was a mere blip on the $58 million due, itself a blip on composite debt of over $70 billion, all of it rated at or near “junk” levels. Yet suddenly the specter of collapse has become real. Moody’s Vice President Emily Raimes, terming the partial payment a “default,” stated: “This event is consistent with our belief that Puerto Rico does not have the resources to make all of its forthcoming debt payments. This is a first in what we believe will be broad default on commonwealth debt.”

National Legal and Policy Center in December 2013 explored in detail the facts and historical context of Puerto Rico’s worsening debt crisis. The island, a territorial commonwealth since 1952, is part of the United States.  And its residents have enjoyed automatic U.S. citizenship since 1917. Yet due to geographic, linguistic, economic and other factors, it is not a state. The statehood option did receive 60 percent support among voters in a nonbinding plebiscite in 2012, but that share did not take into account the half-million voters who left their ballots blank. As for independence, Puerto Rican voters in that plebiscite, and several preceding it, overwhelmingly have rejected it. Most its 3.6 million residents accept, grudgingly or not, their territorial status. The issue is how much longer can the arrangement be sustained. The Puerto Rican government owes creditors about $73 billion (some estimates, a bit more generous, put the figure at $72 billion). That sum, roughly double from a decade ago, amounts to about $20,000 for every resident on the island. On a per capita basis, that’s more than 15 times the median figure for the 50 states as a whole, notes Moody’s Investors Service. Island officials predict this to increase to $40,000 by 2025. Americans are tethered to this high-risk debt. In recent years, more than 50 mainland municipal bond funds have at least 10 percent of their assets invested in Puerto Rican bonds, historically attractive because of high yields and exemption from federal, state and local taxes. There is no money in their treasury to pay the money back; island officials recently estimated the Fiscal Year 2015 budget deficit at between $705 million and $740 million.

Related to this disastrous fiscal situation are social and economic indicators to match. Despite having no tax on domestically-derived personal income, the island has been in a recession for nearly a decade. And it’s getting worse. Factories long have been closing.  But in addition, unemployment has been running at around 15 percent. A third of the residents are on food stamps. Housing prices are collapsing. A consultant’s report prepared for Puerto Rico’s Government Development Bank and released in late June observed that many island residents find it more advantageous to collect public benefits than to hold a job. The government has imposed severe water use rations. Crime rates are far higher on the island than on the mainland. And the pension system, with $37 billion in long-term liabilities, is insolvent, so much so that this May the government announced that its main retirement system had only seven-tenths of a penny in assets for every dollar in liabilities.

In response to this economic unraveling, Puerto Ricans are voting with their feet – northward. The numbers tell the story. According to a study released a year ago by the Washington, D.C.-based Pew Research Center, net annual Puerto Rican outmigration to the U.S. mainland during 1980-90 was 13,000.  During 1990-2000, the figure dropped to 11,000.  By contrast, during the four-year period 2010-13, net outmigration was a staggering 48,000. All told, about three-fifths of all Puerto Ricans now live in the continental U.S.  Roughly a million live in Florida, the Miami-Dade County, Orlando and Tampa areas the most common destinations. “We’re in unprecedented territory because this is, in recent memory, the biggest out-migration that Puerto Rico has experienced,” remarked Mark Lopez, head of Pew’s Hispanic Trends program and a co-author of the study. If this bum’s rush to the mainland continues, Puerto Rico in a very short time will become a ward of its creditors.

Puerto Rican officials know all this. That’s why they’ve been stepping up the pressure on Washington for aid. Governor Alejandro Garcia Padilla (in photo), who has admitted his island’s debt to be “not payable,” declared shortly thereafter in a televised address on June 29: “Those who want the support of Puerto Ricans must help Puerto Rico now…not in a few months during the elections.” He added: “We cannot allow the heavy weight of the debt to bring us to our knees…This is not about politics. It’s about math.” Gov. Padilla has put together a working group to develop a reorganization plan. Its results are due out by the end of this month.  Meanwhile, here in the states, Bronx Borough President Ruben Diaz Jr., whose parents were born on the island, explained how he would deal with the situation: “I have and will continue to push for federal legislation that would allow the Commonwealth of Puerto Rico to declare bankruptcy and restructure its debt. This course of action is a better plan that simply allowing the island’s government to default, and I hope that Congress will act on this grim news with haste.”

The White House has stated for the record that it does not support bailing out the island – at least not directly. Indirectly, however, is another story. Since 1984, Puerto Rico’s public authorities, unlike state government authorities, have been barred under federal law from declaring bankruptcy as a means of obtaining relief from creditors. A growing number of lawmakers want to treat Puerto Rico as our de facto 51st state to repeal that law. On July 15, Sens. Richard Blumenthal, D-Conn., and Charles Schumer, D-N.Y., introduced a bill known as the Puerto Rico Chapter 9 Uniformity Act. The measure, which thus far has attracted at least 10 co-sponsors, would authorize Puerto Rican public agencies to shield themselves from creditors in order to restructure debt on favorable terms. The bill is identical to one sponsored in the House (H.R. 870) earlier this year by Puerto Rican Democratic Resident Commissioner (the territorial equivalent of U.S. Representative) Rep. Pedro Pierliusi.

Supporters of the measure insist this approach is a bargain for Puerto Rican and mainland taxpayers alike. Sen. Blumenthal insists that the measure is “not a bailout,” but a rational, orderly way of restructuring debt. Pierluisi, who heads the island’s pro-statehood New Progressive Party, likewise defends the effort. On June 30, in a prepared statement, he stated:

H.R. 870 does not require the federal government to spend a single dollar. It would simply grant the government of Puerto Rico a power that all state governments have, namely the ability to authorize one or more of its insolvent public enterprises to work out a path forward with its creditors under the supervision of a federal bankruptcy judge based on federal substantive and procedural law…The alternative is a legal no man’s land that benefits neither Puerto Rico nor those who have loaned the territory money.

Pierluisi emphasized that his bill has generated support from a broad spectrum of interests and views, such as Fitch Ratings, Banco Popular, the Puerto Rico Chamber of Commerce and former Georgia Republican Congressman and House Speaker Newt Gingrich.

Democratic presidential candidates, enamored of both a large public sector and multiculturalism, haven’t been bashful about their support. On June 30, ostensible Democratic frontrunner Hillary Clinton sent the following tweet to followers: “Puerto Rico’s debt crisis is not theirs alone. For PR’s economy to grow & their people to thrive, they need real tools and real support.” Another candidate, former Maryland Governor Martin O’Malley, was even more enthusiastic. “I am very concerned about the impending financial collapse of Puerto Rico,” he said. “We must help our fellow U.S. citizens, not only because it’s the right thing to do, but because our region’s economic stability depends on it.” O’Malley, in fact, favors putting Puerto Rico on par with other states not just for the bankruptcy code, but also for contributions to Medicare, Medicaid and the Affordable Care Act. Vermont Independent Senator Bernie Sanders, an avowed socialist, also joined in. On June 30, he announced his support for making Puerto Rico eligible for Chapter 9 protection. Sanders wants the island government to “restructure its debt in a rational way that does not harm its people, ordinary investors or pension funds in the United States.” The debt crisis, he emphasized (as if one could not have guessed), was the result of “policies of austerity and the greed of large financial institutions.”

Don’t assume that Republican presidential candidates won’t join them. Indeed, at least one candidate, former Florida Governor Jeb Bush, already has. While on the campaign trail this April in San Juan, he expressed his support for granting the island Chapter 9 authority. “Puerto Rico should be given the same rights as the states,” Bush declared. Another candidate, Marco Rubio, a sitting U.S. senator from Florida who co-sponsored the highly misguided 2013 “Gang of Eight” immigration surge/amnesty bill passed by the Senate (but not the House), also could support making Puerto Rico into a de facto state; his future might depend on it. And while frontrunner Donald Trump thus far has been the only presidential candidate in either party to raise inconvenient facts about the negative consequences of mass Hispanic immigration, he also may be compromised by his business interests on the island. He is a partner in the Trump International Golf Club, a resort east of San Juan.

Governor Padilla knows that an economic renaissance is the catalyst to any recovery. He explains:  “My administration is doing everything not to default. But we have to make the economy grow. If not, we will be in a death spiral.” Few would dispute these words. Yet Padilla might not be able to break free of a mindset common to island governance. On one hand, the U.S. made Puerto Rico into a tax haven via Section 936 of the IRS tax code; the law, enacted in 1976, was repealed two decades later, with a 10-year phaseout period. The island under Padilla’s predecessor, Luis Fortuno, in 2012, also enacted a law providing generous exemptions from corporate, personal and capital gains taxes for anyone maintaining residence for at least 183 days a year. That latter law has induced about 250 persons with a net worth of at least $1 million to resettle on the island. On the other hand, the Puerto Rican government has had few problems with raising general tax rates. Crucially, this July 1, a sales tax hike from 7 percent to 11.5 percent went into effect. The government had instituted the increase in coordination with deep cuts in government employment and pensions, plus steep rises in utility rates that may wind up reducing usage.

Speaking of utilities, the government-owned electric company, Puerto Rico Electric Power Authority (PREPA), owes its creditors about $9 billion, yet customer rates are two and a half times the U.S. average. PREPA power plants, whose median age is 44 years, consistently have violated Environmental Protection Agency mercury limits. Just as ominous, they often fail to function, triggering periodic blackouts. And many of its service trucks are obsolete, if they are operable at all. Electric power production and delivery isn’t the only example of gross inefficiency. Over the past decade public school student enrollment in Puerto Rico decreased by about 40 percent, yet the number of public school teachers during this time increased by 10 percent. The aforementioned consultant’s report, co-authored by Anne Krueger, former chief economist for the World Bank and former deputy director for the International Monetary Fund, said that 150 Puerto Rican agencies routinely run up deficits every year, with about $300 million to $400 million worth of capital expenditures disappearing. Gov. Padilla, to his credit, has instituted austerity measures. Yet this approach has had the disadvantage of accelerating the exodus to the mainland, especially by young adults.

The core of Puerto Rico’s economic descent can be explained by excessive borrowing. In fact, Puerto Rico has done so much borrowing, and on such easy terms, that the current crisis can be said to be an accident waiting to happen. Income on Puerto Rican bonds for decades has been exempt from all federal, state and local taxes, making them an attractive investment for many people, especially retirees. Though an appealing idea, in practice this has enabled government waste and fraud, and ultimately has lowered credit ratings. It’s a classic reinforcing cycle in the bond market: A high risk of default lowers the price that borrowers are willing to pay. This, in turn, raises yields and the risk of default. Borrowers with a stomach for risk might be enticed, but in practice all this has forced the Puerto Rican government to devote a higher portion of its budget for debt service – and a smaller portion for everything else. This drives even more residents away, chipping away at tax revenues and thus making bonds ever more risky.

Who loaned out all this money? Actually, a lot of us did, and often through financial intermediaries. According to the investment consulting firm, Morningstar, 377 out of 1,884 U.S.-based bond mutual funds – more than 20 percent – hold a combined $11.3 billion worth of Puerto Rican debt. Hedge funds hold another $15 billion. The remainder, the bulk of the debt, is held by individual investors, mainly on the mainland and in Puerto Rico. Among the major institutional investors are Oppenheimer and Franklin Templeton bond funds. Puerto Rican bonds account for at least 15 percent of the holdings of Oppenheimer Rochester municipal funds and nearly half the holdings of Franklin Templeton’s Franklin Double-Tax-Free Income Fund, the latter with an unenviable 1-star (out of five) rating from Morningstar. “To tell you the truth,” says Alan Valdes, director floor trading for DME Securities, “Puerto Rico is a bigger problem for American investors than Greece. Most American investors have little exposure to Greece at all.”

If the island government can’t pay these debts, any number of U.S.-based funds will go to court to get their money back. A spokesperson for Oppenheimer explained the situation politely several weeks ago: “We expect Puerto Rico to act within the tenets of the law, including the Commonwealth’s Constitution, and are ready to defend the previously agreed-to terms in each and every bond indenture.” Similarly, the co-heads of Franklin Templeton’s municipal bond group stated in a blog post: “At the very least, in our assessment, Puerto Rico can expect creditors to seek legal affirmation and protection of contractual rights.” Put less politely, the Puerto Rican government can expect to be sued. And if it can’t work out alternative repayment arrangements, it will enter what amounts to virtual receivership.

At this point, Puerto Rico’s only option, at least to maintain a semblance of autonomy, would be to declare Chapter 9 bankruptcy. Most Democrats in Congress, long advocates of a large welfare state and multiculturalism, don’t have much of a problem with this.  Most Republicans, by contrast, generally do. Yet political urgency could change the latter situation. GOP party leaders, strategists, fundraisers and donors are pulling out the stops to win the 2016 presidential election; for them, three defeats in a row would be almost too much to bear. They know as well as anyone that without Florida, with 29 electoral votes and a rapidly expanding Puerto Rican voter base, recapture of the White House would be highly difficult. Barack Obama barely won Florida in 2012 over Republican challenger Mitt Romney by 50 to 49.1 percent. Former Florida Governor Jeb Bush, for one, is prepared to do what it takes to put his party over the top. He’s an old hand at this. Back in 1980, he worked for more than two months on his father’s presidential campaign, delivering more than 75 speeches in Spanish. This past April, in a visit to Puerto Rico, speaking in Spanish, he made clear his preference for full statehood. “I think statehood is the best path,” he said. “To get the full benefits and responsibilities of citizenship, being a state is the only path to make that happen.”

But will Puerto Ricans here, as automatic U.S. citizens, pull the levers for Jeb Bush or any other Republican candidate? Recent data gathered by the Seattle-based polling firm Latino Decisions suggests they would not. Puerto Rican voters in Florida, Latino Decisions found, went 72 percent to 28 percent for Barack Obama over Mitt Romney in the 2012 presidential election. And fully 42 percent of Florida Puerto Ricans rated Bush as “very unfavorable,” compared to the 10 percent who rated him as “very favorable.” Hispanic activists are working overtime to make sure candidates in both parties toe the pro-immigration line. Soraya Marquez, Florida coordinator for the far Leftist nonprofit group, Mi Familia Vota Education Fund, says her volunteers regularly set up camp at supermarkets, housing complexes, festivals and other public gathering places to ask the locals if they are registered to vote. If they are U.S. citizens, the group then asks for a Florida driver’s license or other ID, and helps them register. It’s hard to imagine a more misguided Republican election strategy than a massive, time-consuming and costly Hispanic “outreach” that would produce no real reciprocation. Yet Republican consultants now are conducting such a campaign.

If advocacy of formal statehood remains a minority view, advocacy of de facto statehood – and that is what the Chapter 9 bankruptcy legislation is all about – is increasingly popular. And passage would ease the way to formal statehood. As I argued in December 2013, statehood is the ultimate bailout. With such status, Puerto Rico would be eligible for a wide range of federal aid. And its congressional delegation, with voting rights, more effectively would veto opposition to expanding levels of federal aid. Placing Puerto Rico’s status on par with that of Florida, Illinois or Minnesota, would forcibly enlist the American people to subsidize fiscal ineptitude in perpetuity. That’s why Congress, the current administration, and all future administrations should tell Puerto Rican officials to resolve their self-created fiscal problems on their own.

Related:

Will Puerto Rican Bonds Trigger a Mainland Bailout?