Nein on Nine

Chapter 9 federal governmental bankruptcy is available only for “municipalities” (a political unit that is less than a state). States and territories have no recourse under existing bankruptcy laws. Bad news for Puerto Rico, which is currently lobbying Congress to expand the definition of bankruptcy to include territories. Why does it matter? Because Puerto Rico’s Governor, Alejandro García Padilla, announced that the U.S. territory was unable to pay its currently due $72 billion of debt. The feds have pretty much told Padilla that Puerto Rico cannot expect a bailout, so they are pretty much on their own.

America’s “Greece” is a pretty tiny area with a slowly declining population of 3.75 million. But its proclivity to float bonds for one governmental purpose or another is a tad extreme: it currently holds bond debt that is fifteen times the average bond debt of all 50 states. Over six times of the bond debt of California. Their debt completely eclipses bond-debt-average of the next five highest states – Connecticut, Massachusetts, Hawaii, New Jersey, New York and Washington – by a factor of three. When you compare the populations and the relative GDPs, Puerto Rico is beyond profligate. The debt averages about $40,000 for every PR citizen.

It was just too easy. The earnings from such bonds offer tax-free revenues to the buyers. There were always financial institutions around to structure and sell these bonds to big funds, other institutional buyers and federal taxpayers looking for tax-sheltered income. Such a deal. For Puerto Rico, it was simply a way to finance projects and governmental budget deficits that simply weren’t covered by the tax base. U.S.-based governmental bonds have traditionally been viewed as pretty low risk investments.

To make matters so much worse is the territory’s abysmal economy. Puerto Rico sports the highest unemployment rate – 16.5% – of any American state or territory. Unlike the feds, who can just print money (actually, technically, increasing money supply and raising the debt limit), states and territories are forced to borrow in the open market (with a little tax incentive) to fill any financial voids in their budgets. PR governmental pensions are underfunded, and this horrific condition threatens the territory’s ability to provide even basic governmental services.

This hovering PR default is also deeply embedded in too many financial holdings across the land. While you may not directly own such bonds, your investments may still be at risk “below the radar.” “Mutual fund companies snapped them up, sprinkling Puerto Rican debt into their tax-exempt bond funds, which bear the names of the various states — New York, Pennsylvania, Virginia and others — where the tax-averse investors lived. It is estimated that 75 percent of the mutual funds tracked by Morningstar now hold at least some Puerto Rico debt.

“And sometimes it is more than just a sprinkling, as mutual funds look to increase their returns. The Oppenheimer Rochester Maryland Municipal Fund, for example, held more Puerto Rico bonds than Maryland bonds as of May 31: 49.7 percent compared with 45.3 percent. Maryland’s credit rating is AAA, so its low-risk bonds offer just a sliver of a reward. Puerto Rico bonds are riskier, so they yield more, and adding them to the mix increases the return.

“The Oppenheimer Virginia fund is 40.2 percent Puerto Rico bonds, and its North Carolina bond fund has 35.3 percent. The holdings are disclosed on its website. A spokesman said Oppenheimer believed Puerto Rico had enough money to repay all of its debts.

“As if that wasn’t enough, Puerto Rico made borrowing even more attractive. Its constitution contains an unusual clause that requires general-obligation bonds to be paid ahead of virtually any other government expense. And in case more reassurance was needed, the government created backstops, lockboxes and guarantee mechanisms for general-obligation and other types of debt, identifying specific revenue streams and promising them to certain groups of bondholders… This practice is not at all unusual, especially in cases of deep distress, because local governments still have to borrow, even when they are broke.” New York Times, June 30^th.

The ramifications for Puerto Rico, short and longer term, are filled with complexity and a path of financial pain that is likely to stretch well into the distant future. And even now, the scramble to get that debt paid is pure and unmitigated chaos without any obvious solution. “Without the automatic stay of bankruptcy, a ‘negotiated moratorium’ that Mr. García Padilla said he wants could swiftly devolve into a destructive and Darwinian creditors’ free-for-all.” NY Times.

Puerto Rico is raising taxes and cutting services, but its economic condition is intolerable. With the current debt crisis in the crosshairs, the territory is obviously going to lose this financial structuring alternative for the foreseeable future. “New York Times DealBook (June 30^th) provides the view from the financial community that structured and placed the debt: “Even debts that appeared to be secure now seem in jeopardy, sending hedge funds and other investors scrambling to re-examine their legal rights and potential remedies should the government push for a restructuring.

“A vast restructuring of the commonwealth’s bonds could scare away more risk-averse investors from buying them for many years to come, causing major problems for the hedge funds… ‘Those investors are not coming back,’ said Robert Donahue, a managing director at Municipal Market Analytics. ‘The hedge funds miscalculated and they are feeling the pain.’

 “Some analysts say the governor’s announcement may have been intended in part to drive down the value of the hedge funds’ bonds so that the firms would be more willing to agree to concessions in order to minimize their losses… ‘The Puerto Rico government has engaged in the creation of a crisis where there isn’t one,’ said Hector Negroni, a principal at Fundamental Advisors, which owns Puerto Rico debt. ‘But I don’t think they will ultimately flout the rule of law. At the end of the day, they need to borrow money again. And no one will lend them money if they break the Constitution.’”

Keep saying that to yourself Hector and maybe it will come true. Exactly what do you think that anyone can do except negotiate a settlement that makes everyone miserable? The governor’s scare tactics are a necessary part of the showdown, but how do you solve this problem and allow the normal and expected operations of government to continue without lots and lots of sacrifice and pain? Think raising taxes will bring more companies to Puerto Rico anytime soon and boost that economy?

How exactly do the folks in Puerto Rico feel about it all? “On the first day of the new sales tax, which jumped to 11.5 percent from 7 percent, the government’s latest rummage for more revenue, Puerto Rico’s malaise was unmistakable. … ‘People don’t even answer you when you tell them, ‘Buenos dias,’ ’ said Ibrahim Baker, 55, on [July 1^st] as he stood at the cash register of the bakery he has owned for 25 years. ‘Everyone is depressed.’…

“With so many bracing for another slide toward the bottom, the sense of despair grows more palpable by the day… ‘So many people are leaving you can’t even find suitcases,’ said Erica Lebrón, 30, as she sat outside a housing project bodega… Before long, Puerto Ricans will face more tax increases — the next one is in October. Next on the list of anticipated measures, these for government workers, are fewer vacations, overtime hours and paid sick days. Others in Puerto Rico may face cuts in health care benefits and even bus routes, all changes that economic advisers say should be made to jump-start the economy.” New York Times, July 3^rd.

Looks like folks are jumping out of the economy. A good time to buy a retirement home on the beach? Is Puerto Rico America’s Greece or is this demise nothing short of the canary in the coal mine, a reflection of the greater malaise that is facing a world with growing populations and dwindling resources? Time will tell, but whatever the result, it is high time we began learning from our many, many mistakes. 

I’m Peter Dekom, and all over the world, massive national debt – including our own – is increasingly the stuff of headlines.