Deciphering Puerto Rico’s Debt Crisis

Special tax incentives have enabled Puerto Rico to borrow irresponsibly for years, and now the island must take painful steps to balance its budget, explains expert Matt Fabian.

July 15, 2015

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To help readers better understand the nuances of foreign policy, CFR staff writers and Consulting Editor Bernard Gwertzman conduct in-depth interviews with a wide range of international experts, as well as newsmakers.

The Governor of Puerto Rico, Alejandro Garcia Padilla, announced in late June that the island’s debt burden was "unpayable," sparking fears of default and raising questions about Puerto Rico’s future. The commonwealth, which has been a U.S. territory since 1898, "has been in denial" about its roughly $73 billion in debt, and the capital markets "have finally woken up to the risks," says Matt Fabian, a partner at Municipal Market Analytics (MMA).

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The island has continued to borrow large sums, mostly from U.S. investors seeking special tax exemptions, despite a decade of recession, a shrinking population, and deteriorating public finances, Fabian explains, and its debt is "roughly twice the size" of what is currently being portrayed in the media. However, there is little risk that Puerto Rico’s debt crisis will spillover into the rest of United States, and the federal government is unlikely to intervene there unless there is social unrest, he says. Ultimately, Fabian says, Puerto Rico will need to address the crisis on its own.

A man waves a Puerto Rican flag during a protest in a May 2015 protest in San Juan. University students and employees took to the streets to oppose proposed cuts to public university budgets.Puerto Rican university students and employees protest proposed cuts to public university budgets in a May 2015 demonstration in San Juan. (Photo: Alvin Baez/Reuters)

Why is Puerto Rico unable to pay its debts?

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The better question is: Why are they now finally admitting that their debts are unpayable? Puerto Rico has gotten by for years in large part by borrowing to bail out its budget year after year. Lenders accepted it because there was no sense among the investing public that things were as unsustainable as they were. Fundamentally, Puerto Rico is contracting. The island’s economy expanded in large part due to tax incentives that expired starting in the 1990s, and the 2008–2009 recession amplified the contraction. People have been leaving Puerto Rico in droves [as U.S. citizens, Puerto Ricans can move to the mainland any time, and currently more than 50,000 people are leaving each year].

Puerto Rico has been in denial that its debts were ultimately unpayable. There’s been a general expectation on the island that it could at some point restart growth so as to be able to pay off its debts. But growth continues to weaken, and out-migration trends are only accelerating. The capital markets have finally woken up to the risks and are charging Puerto Rico unsustainably high interest rates—10 percent or higher—with very difficult terms for the commonwealth. When you’re dependent on capital market access, the loss of that access is a substantial problem.

Is there a precedent for the severity of this situation elsewhere in the United States, or is this a function of Puerto Rico’s special status as a U.S. Territory?

There isn’t a great precedent. There are analogies to Detroit [which filed for bankruptcy in 2013], but only to an extent. Detroit’s economy was in decline for fifty years, but the city was able to reduce its spending and jump-start its revenues through new taxes. Detroit’s debts were fundamentally affordable, like how a house with a $100,000 mortgage is affordable until you lose your job. For Detroit, it wasn’t the debt so much as it was the loss of revenue.

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"Puerto Rico has been in denial that its debts were ultimately unpayable."

In Puerto Rico, they decided to keep spending quite high throughout the recession, as a sort of fiscal stimulus. And it went on for a very long time, so rather than just having a $100,000 mortgage, they have the mortgage, the equity loan, and maxed out credit cards. For Puerto Rico, the debt has become the real problem.

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Puerto Rico was able to do this because of its special tax incentives: The island has had such great capital market access because their bonds are triple tax-exempt [meaning that investors, no matter where they live in the United States, can avoid local, state, and federal taxes on the interest from Puerto Rican bonds]. Generally, the municipal bond market is really fifty smaller markets, since tax exemptions normally apply only to residents of a particular state. If I live in Massachusetts, I buy Massachusetts bonds; if I live in Connecticut, I buy Connecticut bonds. But Puerto Rican bonds, because they are tax exempt everywhere in the United States, are universal for municipal portfolios. The market has very few securities that fit that bill.

What was the original rationalization for that tax-free status?

Puerto Rico is, legally, a ward of Congress, and a U.S. territory. The 1917 Jones-Shafroth Act barred any of the states or localities from taxing the interest on Puerto Rico bonds, as well as those of any U.S. territory. It’s a function of the idea that, in theory, they are smaller and weaker and need extra care, and the triple tax-exemption helps them get market access.

Puerto Rico doesn’t have access to Chapter 9 bankruptcy, the legal process through which cities, towns, counties, and other U.S. municipalities can discharge their debts. What options are available to the island’s leaders?

Well, default is always an option. They can simply decide to stop paying and let the legal system address who’s right and who’s wrong in a very ad hoc and disorganized way.

A better option is what they seem to be pursuing—organized negotiations with bondholders. Major bondholders could agree to concessions on time of repayment, interest rates, or possibly on the size of the principal itself. Hopefully they can get enough investors interested in doing that to a create real savings. But Chapter 9 bankruptcy was created in the first place [in 1937 during the Great Depression] because without the intervention of a bankruptcy court, municipal governments had no other way of compelling bondholders into taking any kind of loss. For municipal bonds, you need 100 percent bondholder approval to agree to any weakening of the terms of the bond. That’s just not possible, especially when you have, as in the case of Puerto Rico, probably tens of thousands of bondholders, many of them small, retail investors.

"Major bondholders could agree to concessions on time of repayment, interest rates, or possibly on the size of the principal itself."

Thus, Puerto Rico will have to get enough of the large bondholders to agree to concessions. They’ll probably do it through some kind of voluntary tender offers, where they say they are willing to pay 75 cents on the dollar, or 50 cents on the dollar, or whatever the level is. Or, creditors may be willing to buy back the bonds and give Puerto Rico new bonds that mature ten years further out, with lower interest rates. Changing the terms like this could at least create some cash flow for the commonwealth, and give them time to get their act together. But ultimately, they probably need to take fairly large haircuts across all of their debt, not just delayed payment.

What role can the federal government play? Will it step in?

There’s no momentum at this point from the federal side. What the federal government has done, through the Treasury Department, is to act as an observer and facilitator to try to get people together to work out a solution. The U.S. Treasury doesn’t have the authority to give Puerto Rico the kind of money that it might need. That kind of bailout would have to come from Congress and is almost surely impossible due to anti-bailout sentiment among both Republicans and Democrats.

"The federal government is unlikely to get involved unless there is social unrest caused by drastically worsening financial conditions."

Congress is debating the current Chapter 9 bill [to give Puerto Rico the legal ability to declare bankruptcy], and it’s making some progress as conditions get worse on the island. But for whatever reason it has become a partisan issue, with senior Democrats lining up in favor. There’s also talk about the potential creation of a federal control board like Congress imposed on Washington, DC [between 1995 and 2001], or some other kind of special fiscal manager.

Ultimately, Congress has plenary power over Puerto Rico and could do what it chooses. But the federal government is unlikely to get involved on the island unless there is social unrest caused by drastically worsening financial conditions.

Is that possible if Puerto Rico can’t come to a deal with their creditors?

That might be in the cards regardless of what they do with creditors. The island’s stakeholders—the unions, the public employees, the taxpayers—have not really organized in protest against this mismanagement. If they begin to mobilize, it makes that scenario more likely. For the most part, the creditors are represented by large hedge funds and bond insurers, neither of which get much sympathy from the main street crowd.

Are there implications for the rest of the U.S. municipal bond market? Will it become more expensive for other state and local governments to finance themselves?

Probably not. The situation in Puerto Rico has been coming for a very long time. I don’t think that there’s any real risk of credit contagion, where if Puerto Rico were to default, people would then worry more about Illinois or New York or New Jersey. They’re such different animals. The main narrative in the market is that Puerto Rico is a unique situation.

Most of Puerto Rico’s debt issuance, particularly in the last decade, has been to finance its deficit. Market wide, probably 95 percent of municipal bonds are sold for infrastructure. It’s very rare for a local government to rely so heavily—really to rely at all—on borrowing to finance their budget. Some states have done it periodically—Illinois did it with its pension bonds a couple years ago, and New Jersey has done it a bit—but nothing like the scale of Puerto Rico, which has billions and billions of dollars of outstanding bonds sold just to finance deficits.

By the way, the island’s debt is $73 billion in face value, but what’s owed is probably closer to $80 billion because they have a large number of zero-coupon bonds [bonds which pay interest in a lump sum at the time of maturity] that have grown in value. In addition, Puerto Rico has about $40 to $45 billion in unfunded pension liabilities, and it owes at least another $10 to $15 billion in retiree medical benefits. So the debt is much bigger than what is being portrayed in the media—roughly twice the size.

Given the recession and the austerity measures Puerto Rico has already had to undertake, what is its path back to growth, or any sort of sustainable economy?

They’re probably looking at a series of restructurings. Currently, they seem headed toward half steps and partial restructurings that are ultimately based on the idea that things will get better in the near term. The most likely scenario is that they wind up restructuring their debt only to have to restructure it again later.

"Puerto Rico’s debt is much bigger than what is being portrayed in the media—roughly twice the size."

But raising taxes—there was just a major increase in the sales tax—is only going to undermine the economy further. Any way of raising revenue is going to hurt economic growth, and any kind of cut back in public spending, because there is so much of it, is also going to hurt growth. Since these are American citizens, they can move [to the mainland] any time. So out-migration is likely to accelerate.

The next steps are generally grim. There isn’t an external source of capital, like even Greece has with the IMF, to come in and help refinance the debt, to help restructure and provide some breathing room. There just isn’t that kind of latitude. Things don’t look good for Puerto Rico.

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