It is now official: Puerto Rico is broke. Last Wednesday, on May 3, the island territorial government, unable to meet its commitments on more than $70 billion in bonds and nearly $50 billion in employee pensions, declared bankruptcy. As far as municipal bond defaults go, it is the largest in U.S. history. Mismanagement and corruption have had more than a little to do with this meltdown. Congress paved the way for receivership last June when it passed legislation granting Puerto Rico protection from certain bond creditors. As the island slides toward oblivion and its residents leave in droves, the emergency control board created by the law has begun to oversee budget restructuring. The long-run challenge ought to be weaning the island from its federal fiscal lifeline and ultimately from the United States itself.
National Legal and Policy Center has covered this unfolding fiscal disaster three times, most recently last June in the wake of passage on June 9 by the House of Representatives by a 297-127 margin of the Puerto Rico Oversight, Management and Economic Stability Act, or PROMESA. The law, a supercharged version of Chapter 9 of the U.S. Bankruptcy Code (without actually being Chapter 9), is also known as Title III. The Senate passed the measure by 68-30 on June 29, two days before the payment deadline of $2 billion worth of bonds; President Obama quickly signed the bill into law. PROMESA – the acronym for “promise” in Spanish – authorized the Puerto Rican government to shield itself from bond creditors owed about $18 billion, about a fourth of the total estimated island bond debt of $73 billion.
This is a first in U.S. history, and a rather unenviable one: A U.S. territory has gained access to bankruptcy protection. In return, Puerto Rico will be subject to close supervision by a seven-member bipartisan control board with the power to do the following: supervise negotiations between bond creditors and the courts; advise and approve annual budgets; mandate steps for pension plan solvency; order public-sector layoffs; and recommend privatization of services and assets. In these and other activities, the board would be required to conduct good faith negotiations.
The arrangement is similar to the receivership imposed by Congress upon the District of Columbia local government during the second half of the Nineties. Federal lawmakers effectively stripped Mayor Marion Barry of his authority. In the end, the District of Columbia recovered from its fiscal crisis. Puerto Rico might not. Setting its house in order will be far more expensive and lacks the wealth of the mainland.
Defenders of PROMESA, such as House Speaker Paul Ryan, R-Wisc., insist that the law is not a bailout because it does not use taxpayer funds. The assertion may be true in fact, but it is false in spirit. The law is a bailout. The issue is who gets bailed out and who pays. Puerto Rican Governor Ricardo Rossello Nevares, a supporter of the law, speaks of “shared sacrifices.” But sharing doesn’t automatically mean doing so equally. Given the state of the island economy, mainland bondholders may have to reconcile themselves to accepting pennies on the dollar. And taxpayers might be forced to retire Puerto Rican debt anyway if their government cannot meet the board’s generous terms. A number of lawmakers on the Democratic Party Left, in fact, including Senators Cory Booker (N.J.), Robert Menendez (N.J.) and Elizabeth Warren (Mass.), opposed the PROMESA bill not because it was a bailout, but because it didn’t include any appropriations.
How did things get to this point? One would think that Puerto Rico, a 3,515-square-mile Caribbean island with a population of 3.5 million, has too much going for it – for starters, a year-round warm climate, fertile soil, beautiful beaches and historically significant tourist attractions. Its residents have enjoyed automatic U.S. citizenship since 1917, and since 1952 the island has been a constitutional commonwealth. And Congress has seen to it that the island is investor- and resident-friendly. Puerto Rican residents living on the island do not pay any federal personal income tax. Interest on Puerto Rican bonds from 1917 onward has been tax-free. And Section 936 of the IRS Tax Code, which granted U.S.-based corporations a tax exemption on income earned in Puerto Rico. Many firms, especially pharmaceutical companies, took advantage of the law, which had been enacted in 1976, expanding operations to the island. It is true that Congress repealed the law in 1996 as part of the Small Business Job Protection Act, with a ten-year phaseout period. But to attribute most of the island’s recent woes to that move would be a wild exaggeration. Somehow a great many U.S. mainland corporations have managed to thrive without such a tax break.
Island officials, confident that a favorable climate for growth could ward off the consequences of fiscal profligacy, went on a seemingly nonstop borrowing and spending binge. The island’s Government Development Bank, now soon to be phased out, financed the construction of a convention center, not to mention power generating plants, golf courses, hotels and apartments. The bank currently owes some $4.5 billion to bondholders. The Puerto Rico Aqueduct & Sewer Authority and the Puerto Rican Electric Power Authority each owe billions as well. The power authority, which worked out a $9 billion repayment plan two years ago, sharply raised customer usage rates to cover its losses. Even after the expiration of Section 936 in 2006, the island government continued to borrow heavily. During 2006-14, Puerto Rican public debt grew by $28 billion. Bond debt now accounts for more than $20,000 for every man, woman and child on the island. Including pension debt raises this per capita figure to around $34,000. Per capita GDP is a little less than $30,000. Put another way, public bond debt is roughly 65 percent of GDP; throwing in (virtually unpayable) pension liabilities raises the figure to somewhere between 110 percent and 115 percent. By contrast, the bond obligation figure for New York, the most indebted state in the nation, is slightly under 25 percent, even including local government debt.
Congress enacted PROMESA last June because bankruptcy was almost inevitable. And the announcement came this May 3. “It is my wish that the government’s Title III processes accelerate the negotiation process by bringing the greatest possible consensus,” said Governor Rossello in a prepared statement in Spanish. It was the largest default in the history of the $3.8 trillion U.S. municipal bond market. The default, estimated at $73 billion, dwarfs even the $18 billion default by the City of Detroit in July 2013. Two days earlier, on May 1, U.S. Supreme Court Chief Justice John Roberts had assigned Puerto Rico’s case to U.S. District Judge Laura Taylor Swain, Southern District of New York, and a former bankruptcy judge herself. The case may be tied up in the courts for years. Bond fund managers are arguing that by averting debt payment, Puerto Rico is violating its own constitution as well as the principle of fairness. By contrast, Puerto Rican advocacy groups say that “greedy hedge funds” caused the crisis and hence should bear the losses.
The role of corruption in all this should not be discounted. In December 2015, 10 Puerto Rican officials and businessmen, including a leading fundraiser for the then-ruling Partido Popular Democratico (PPD), were charged in a 25-count indictment with corruption, extortion, bribery and wire fraud. FBI Special Agent in Charge Carlos Cases, explained: “Unfortunately, this is one more case of graft, greed and corruption that over the last 20 years have contributed to the government of Puerto Rico’s fragile financial condition and on the brink of bankruptcy.” All defendants in the scheme were convicted. There have been other scandals. Jose Gonzalez Amador, owner of Petro West, Puerto Rico’s largest oil supplier, was charged with embezzling $11 million from the Puerto Rico Electric Power Authority. In September 2015, the FBI arrested 10 Puerto Rican police officers for stealing drugs and cash, planting evidence and taking bribes. This was on top of a 2010 FBI sting that netted 89 Puerto Rican cops for corruption, civil rights violations and murder.
Union officials have been corrupt as well. In July 2005, federal prosecutors indicted leaders of International Longshoremen’s Association Local 1740, along with six businessmen and three companies on nearly two dozen counts of embezzlement, money-laundering and maintaining false records in a scheme that cost the union an estimated $10 million. Local President Jorge Aponte-Figueroa and several other accused individuals eventually pleaded guilty. In October of that year, a grand jury indicted 11 members of the executive board representing employees of the Puerto Rico Aqueduct and Sewer Authority for stealing more than $15 million in health care premiums and other assets. Most of the principals, including Aponte-Figueroa, pleaded guilty and received a sentence. And in 2012, Jose Caraballo-Figueroa, head of a union claiming to represent Puerto Rican sugar workers, was sentenced for embezzling $450,000 from its coffers.
If Puerto Rico has a shortage of public accountability, it is facing an even more ominous shortage: people. The Commonwealth of Puerto Rico is now down to around 3.5 million residents and possibly less, a drop of 9 percent during the past decade. In 2014 alone, notes Puerto Rico’s Institute of Statistics, about 84,000 people moved from Puerto Rico to the U.S. (especially to Florida), whereas only 20,000 Puerto Ricans here on the mainland moved to the island. That amounted to a net outmigration of 1.8 percent. The Puerto Rican work force, accordingly, has declined by roughly 300,000 over the last decade. This trend is especially pronounced among younger workers and those with a college or advanced degree. Doctors in particular have been heading for the exit door, exacerbating an already perilous medical shortage.
Large population outflows are both a cause and an effect of a weak economy. As for cause, the New York Federal Reserve Bank concluded in a recent report: “If people continue to leave the island at the pace that has been set in recent years, the economic potential of Puerto Rico will only continue to deteriorate.” As for effect, Jim Millstein, founder of Millstein & Co., a financial adviser to the Puerto Rican government, puts it this way: “The people of Puerto Rico are voting with their feet. The economy is so stagnant that it is driving people off the island, to Florida and Chicago and New York.” Viewed either way, it is a perfect example of a vicious cycle.
Puerto Rican leaders, desperate to avoid a full-scale collapse, have embarked on an austerity program. That may help in the short run, but it also may drive even more people away – at least those who can afford to leave. The indices don’t look good. Early this month Puerto Rico’s education secretary announced a proposal to close 184 schools and cut average teacher work hours by two days a month. That’s in addition to the many school closings since 2014. Up to 400,000 residents are facing the loss of their health plans because they can no longer afford them. Private and public employers are slashing pensions. About a third of all residents are on food stamps and about two-thirds are on either Medicare or Medicaid. Island GDP is contracting at an annual rate of between 1.5 and 3 percent. The poverty rate is 45 percent. The unemployment rate has been hovering between 10 and 15 percent. To help keep basic services running, the government two years ago raised the sales tax rate from 7 to 11.5 percent. Yet aside from the dubious wisdom of taxing one’s way out of a recession, it is hard to see how tax hikes of any sort, given Puerto Rico’s declining tax base, would help. The City of Detroit’s general obligation bondholders managed to recover 74 cents on the dollar; Puerto Rican general obligation bondholders may be lucky to get a tenth of that.
The governor’s office in San Juan got a new occupant at the start of this year: Ricardo Rossello, a populist who ran on the New Progressive Party ticket. While Rossello opposes the PROMESA law, he is trying to minimize the island’s liabilities. “There has to be sacrifice everywhere,” he said. “We have been very clear about what that sacrifice is.” He emphasized in a May 2 letter to Jose Carrion, chairman of the PROMESA Financial Oversight and Management Board, his view that Puerto Ricans have made enough sacrifices. Yet in point of fact, the board already has cut the island plenty of slack. Gov. Rossello’s 10-year fiscal reform plan, approved this March, projects that Puerto Rico will pay $800 million a year in debt service over the first five years. Creditors see this ceiling as unreasonably low, noting that about $3.5 billion worth of bonds will come due each year, a figure comparable to what the island has been paying these past several years. In effect, the board, using the authority of a new law, is offering the Puerto Rican government the equivalent of interest-free loans in excess of $2.5 billion a year. This is a bailout all but in name.
It’s hard to see Puerto Rico pulling out of this muck anytime soon. The City of Detroit managed to pay off most of its crushing debt by soliciting large contributions from nonprofit philanthropies. Puerto Rico does not have such a backstop. And it lately it has been on the receiving end of a blitz of lawsuits from hedge funds and other bond creditors. Though the creditors aren’t necessarily opposed to the PROMESA law itself, they do believe that the emergency board is being swayed by pressure from Puerto Rican activists. “Just as a deal was within reach, we understand that the oversight board intervened to block it,” remarked Andrew Rosenberg, a lawyer for general obligation bondholders. “For months, the oversight board has made every effort to sabotage consensual negotiations.” Worse, the governor’s plan rests on the assumption that revenues will increase despite recent tax and utility rate hikes.
If the Puerto Rican situation further deteriorates, it risks becoming a miniature Venezuela. Last June, there were dozens of food riots in Caracas and other cities in that South American country. Angry, desperate mobs forced their way into grocery stores and stole whatever food was left on the shelves. At least five people were killed. The socialist (and anti-white) regimes of Hugo Chavez and now Nicolas Maduro have transformed what was once a prosperous oil-exporting nation into a poverty case. Puerto Rico recently got a taste of possible things to come. This May Day, thousands, if not tens of thousands, of Puerto Ricans went on a general strike and rallied in the streets of San Juan. “The government is bankrupt,” remarked Bernardo Rivera, a San Juan bus driver. “Everyone is bankrupt. There is nothing left. People who do not have jobs do not take the bus to work.” It is hard to imagine most residents of the island not feeling the same way.
The Puerto Rican saga is a case of socialization of risk coupled with recklessness of borrowing, an example of what economists call “moral hazard.” The term refers roughly to the natural tendency of people to be more reckless with other people’s money than with their own. That, in essence, was the story of the great mortgage meltdown of 2008. Puerto Rico right now is in a hazardous condition. Its people are emigrating to the U.S. mainland in record numbers. Businesses are shuttering. Power companies are raising rates while rationing electricity. Even if Congress does not prop up the island with appropriations, mainland bondholders may be forced to accept a fraction of what is owed to them. And Puerto Rican bonds are (or deserve to be) rated at junk levels. American taxpayers, by the way, are propping up the island via the appropriations process, even if not through PROMESA. The approved and signed fiscal year 2016 omnibus spending bill included $865 million in extra Medicare payments for Puerto Rico.
Now here is the heart of the dilemma: As long as Puerto Rico remains part of the United States, the mainland will be tethered to the island’s economic woes. It is crucial that we understand that minimizing U.S. exposure to the Puerto Rican economic disaster depends on minimizing U.S. political exposure to the island itself. Put bluntly, Puerto Rico needs to become a separate country. The alternatives are not palatable. Easy money under the cover of commonwealth status is what got the island, and the rest of America, into this quagmire. Statehood, aside from the overwhelming geographic and cultural obstacles to full assimilation, would make Puerto Rico eligible for an even wider pot of federal aid and thus render the island even more of a fiscal liability (and a permanent one at that). By contrast, nationhood would force Puerto Rico to manage its affairs more responsibly, as the age of Yankee paternalism would be over. The main obstacle to nationhood, unfortunately, is that most Puerto Ricans don’t want it and indeed lately have been leaning toward statehood. It will take years of tough-minded political leadership to steer the island toward independence. Until then, things are likely to get very expensive for the rest of us.