Puerto Rico Default: How We Got Here And What Happens Next

For the first time, Puerto Rico missed a bond payment Saturday, a major setback for the U.S. commonwealth’s 3.5 million people. The island territory has already suffered a decade of economic stagnation, with high unemployment, rising taxes and recent cuts in everything from university education to senior healthcare. Now that Puerto Rico’s Public Finance Corp. (PFC), a government financing unit, has failed to make a $58 million payment, it will become more costly and difficult for the commonwealth to borrow funds as it attempts to restructure a staggering $73 billion in debt.

“After Saturday, credit-ratings agencies will have something to say about this missed payment,” says Jim Colby, senior municipal strategist at Van Eck Global, a New York investment advisory firm. “The next set of headlines will be which public corporation is next in failing to make a payment, and what the commonwealth’s response to that will be. There’s a huge amount of uncertainty right now.”

Because the deadline was Saturday, the PFC technically has until the end of Tuesday to make its missed payment, but it appears unlikely to make a difference. Victor Suarez, chief of staff for Puerto Rico’s Gov. Alejandro Garcia Padilla, told journalists in San Juan Friday, “We don’t have the money.” A default is thus looming as the commonwealth inches closer to the largest -- and messiest -- government-debt restructuring in the history of the U.S.

“Puerto Rico is in uncharted territory,” says Frank Shafroth, director of the Center for State and Local Government Leadership at George Mason University’s School of Policy, Government and International Affairs.

Puerto Rico faces a grim future. It’s operating with a $703 million budget deficit for the fiscal year that began last month. And the commonwealth faces $635 million in debt-service payments this month, according to the Standard & Poor’s ratings agency. Overall, it has to make $5.4 billion in bond payments through next summer, according to data compiled by Bloomberg. Meanwhile, its fiscal 2015 budget, running through next June, is $9.8 billion, leaving little for services such as trash pickup, road maintenance, education and other government functions.

Puerto Rico will need to borrow more money, but the missed bond payment Saturday just made obtaining future credit a lot more expensive. “A default on the PFC bonds would be further demonstration of increasing unwillingness [of Puerto Rico] to pay debt in full,” David Hitchcock, an S&P credit analyst in New York, wrote in a research note last week.

Lawyering Up

The missed payment is the first since Garcia Padilla admitted last month that Puerto Rico’s debts were unsustainable, ringing alarm bells among creditors and sending the commonwealth’s bond prices plummeting. The missed payment could be the first of several that may lead to complicated fights between private lenders (hedge funds and mutual funds) and public borrowers (Puerto Rico’s municipalities and publicly owned corporations).

Puerto Rico’s indebted central government, municipalities and public corporations cannot file for bankruptcy protection without the OK of the U.S. Congress, which leaves them at the mercy of what could be hundreds of lawsuits filed by creditors.

Unlike Detroit, which achieved an orderly restructuring of its municipal debt in U.S. Bankruptcy Court in 2013, Puerto Rico and its creditors will engage in a protracted and expensive series of legal disagreements inside bank boardrooms and federal courthouses.

“Without a referee in the form of a bankruptcy court, it’s going to be a mess,” Shafroth says. “In Detroit’s case, there were close to 10,000 creditors. Imagine if Detroit had been cut off from bankruptcy with all those creditors lined up, hiring law firms.”

Bankruptcy protection would also ensure that vital public services, such as emergency-call and law-enforcement responses, remain funded, something that is not otherwise guaranteed.

But Puerto Rico is unlikely to get much out of Washington. Despite calls by Treasury Secretary Jack Lew and presidential hopefuls Jeb Bush and Hillary Clinton to let Puerto Rico use bankruptcy court, conservative lawmakers aren’t likely to allow it because they fear the reprisals of constituencies that regard municipal bankruptcies as backdoor bailouts.

Puerto Rico’s Borrowing

Puerto Rico has about 18 different types of bonds, ranging from general obligation bonds, whose payments are guaranteed by the commonwealth’s Constitution, to bonds issued by public corporations, which are responsible for things such as electricity and highways and whose assets could be sold to settle debts.

Over the years, mutual-fund managers have had an incentive to buy Puerto Rican bonds, because their returns are tax-free. Investors have been able to use the commonwealth’s bonds as a way to raise their yields and lower their tax burdens. Mutual-fund managers also have spent years using Puerto Rico’s securitized debt as a way to diversify their portfolios, passively enabling the island’s deficit spending. The mechanism prevented the territory from tackling crucial but unpopular reforms as its debts ballooned throughout the Great Recession.

Investors operated under the assumption that buying Puerto Rican bonds was a so-called safe way to boost returns on investment. The implicit theory was that the U.S. government would back the commonwealth government when things turned sour.

“The warning signs have been out for years about Puerto Rico and its extraordinary debt,” Colby says. “But investors have been making the presumption that Puerto Rico would somehow find support financially from U.S. Congress.”

And now, some mutual funds have such large holdings of Puerto Rico’s debt that they can’t afford to exit the territory. An economic disaster could occur if they all chose to dump their bonds in a short period of time.

Mutual funds with high exposure to Puerto Rico’s debt, such as certain high-risk vehicles at shops ranging from Fidelity Investments to OppenheimerFunds, will fight to avoid taking huge losses. Investors would prefer instead to see debt terms renegotiated -- perhaps with a plan to extend payments further into the future to give the commonwealth room to breathe.

Functioning like payday lenders in a way, hedge funds have been buying bonds at steep discounts. They are now eyeing state assets, such as government buildings and sewage-treatment plants, for privatization in an effort to recover their investments.

And some major government assets have indeed been privatized in recent years. A consortium including a unit of Goldman Sachs Group Inc. in New York now manages two Puerto Rican toll highways, and the asset manager Oaktree Capital Management in Los Angeles is a key investor in San Juan's Luis Muñoz Marín International Airport.

Since 2013, funds such as Aurelius Capital, Davidson Kempner Capital Management, Fir Tree Partners and Monarch Alternative Capital have been piling into Puerto Rico’s debt, and now they intend to turn the screws on the commonwealth to recover as much as they can. (A full list of these funds can be found here.)

Two Different Proposals

Critics say the reason Puerto Rico was able to amass so much debt was because lenders took advantage of the island’s tax-free bond status, and they should accept the consequences of the risks by absorbing the brunt of the pain.

“Investors should suffer the loss,” John Perkins, author of the 2004 book “Confessions of an Economic Hit Man,” said in a recent interview with International Business Times. Perkins is an outspoken critic of the way the financial industry drives countries into crippling debt. “They took a risk. They stepped up to the poker table and lost their hand, but the people of Puerto Rico shouldn’t have to suffer any more than the people of Detroit for this.”

Almost everybody watching Puerto Rico says there’s plenty of blame to go around and that the losses should be distributed on all sides: mutual-fund investors, private wealth managers and the Puerto Rican municipalities and agencies.

But how Puerto Rico digs itself out of this hole is a big uncertainty.

Puerto Rico outlined its strategy last month in its so-called Krueger report. It’s a blueprint for how the commonwealth would cut costs and raise taxes in return for partial debt relief. The report proposes steep spending cuts and reforms of the labor market to promote business growth, which would include lowering the territory’s minimum wage to promote small-business growth.

Released last week, a report commissioned by the major hedge funds invested in the island and titled “For Puerto Rico, There Is a Better Way,” basically agrees with the reforms proposed in the Krueger report, but dismisses the idea that Puerto Rico should receive any debt relief.

Desmond Lachman, resident fellow at the American Enterprise Institute, a center-right think tank in Washington, calls the hedge-fund-backed report “seriously flawed,” with unrealistic expectations. Lachman notes one problem is that the report’s projections of future growth are based on models that apply to countries with their own central banks. Because Puerto Rico is tied to the U.S. dollar and the Federal Reserve, it can’t implement monetary policies that have proven to work in other parts of the world.

“My view is that the right path for Puerto Rico would be to seek an orderly debt restructuring along the lines proposed by the Krueger report,” Lachman, a former deputy director of the International Monetary Fund’s policy development and review department, said by email. “That effort should be accompanied by far-reaching reforms that would restore dynamism to the Puerto Rican economy.”