Puerto Rico (Jul. 23)

Yesterday in midtown, 350 creditors, mainly hedge funds and money managers, gathered to hear from Puerto Rico Governor Alejandro García Padilla, who had announced two weeks ago that the Commonwealth is no longer be able to service its $72 billion debt.  But Padilla promised them only that the government would soon offer formal recommendations for restructuring the debt outside a bankruptcy filing and ending the island’s fiscal crisis, leaving creditors to wait for officials to come up with a plan that is not only fiscally practical, but politically acceptable.

U.S. fiscal policy is implicated in the situation in Puerto Rico, for better and worse.  The downward spiral there began in 1996, when Congress started phasing out the tax break that made subsidiaries of U.S. corporations operating on the island exempt from federal taxes.  Soon, factories downsized or closed and manufacturing employment fell sharply.  As manufacturing slowed, tax revenue withered, leaving the government to borrow heavily to cover its spending.  When the tax credit expired in 2005, Puerto Rico fell into a recession that has yet to end.

Bond market incentives have pushed the day of reckoning off to the point where, today, half of Puerto Rico’s budget is spent on public debt service.  Investors who buy its bonds can exclude the interest paid to them from their taxes, no matter what state they live in.  This feature has made Puerto Rico’s bonds extremely attractive and relatively easy to market.  The practice among mutual funds of competing on the basis of yield, benign neglect regarding the practice of long-term borrowing to plug holes in budgets, and laws that supposedly give bond buyers ironclad guarantees have all fostered investor complacency.

Puerto Rico — with a population of 3.7 million, a median income of $19,624, and a labor participation rate of 40 percent — is nonetheless the third-largest issuer of state and local debt in the United States, behind only California and New York.  On a per-capita basis, Puerto Rico has more than 15 times the median bond debt of the 50 states.   More than 180 municipal bond mutual funds have at least five percent of their portfolios in Puerto Rican bonds.

There could be consequences that shake the municipal bond market and lead to higher borrowing costs for state and local governments across the United States.  Smaller bankruptcies in Detroit and other cities followed now by Puerto Rico might suggest to some investors that loaning money to local governments in this country isn’t always a safe bet and might make new roads, new schools and other projects more expensive.

In the wake of Padilla’s announcement, bipartisan political support, at least in the Senate and among some presidential candidates, materialized fairly cooperation will be on the table.  Many analysts and business people say that forging a lasting solution to the island’s economic problems will require a reworking of its convoluted relationship with the federal government.

Meanwhile, investors must await the officials’ proposal, which will open negotiations that will assume dimensions similar to those between Greece and the E.U., with austerity measures paired with relief in a familiar policy push-me, pull-you.  But there are two important structural differences at play that may ameliorate the consequences for Puerto Rico in the long run:  Puerto Rico will be negotiating with hundreds of creditors, not two dozen European sovereigns, and Puerto Rico’s status as a territory of the United States and the advantages that economic relationship affords are not in jeopardy.


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