When Puerto Rico’s governor told lawmakers and citizens on Monday thatthe commonwealth could not pay its $72 billion in debt, many wondered how a small, seemingly low-key American island in the Caribbean could have amassed a debt big enough to crush it.
The answer lies in a confluence of factors, including American investors’ desire to avoid taxes; the mutual fund industry’s practice of competing on the basis of yield; complacency about the practice of long-term borrowing to plug holes in budgets; and laws that supposedly give bond buyers ironclad guarantees.
That brew of incentives has produced truly staggering numbers. On a per-capita basis, Puerto Rico has more than 15 times the median bond debt of the 50 states, according to Moody’s Investors Service. The governor, Alejandro García Padilla, said on Monday that at the rate the debt situation is developing, every man, woman and child on the island would owe creditors $40,000 by 2025. High unemployment means fewer resources to pay off what is owed.
Comparing Puerto Rico’s Debt
Puerto Rico has about 15 times the median bond debt of the 50 states, according to Moody’s Investors Service.
“We cannot allow the heavy weight of the debt to bring us to our knees,” the governor said in a live televised address, proposing a debt restructuring.
For years, investors were lining up to lend Puerto Rico money, so it was easier to borrow than to fix any number of financial or structural shortcomings. Many of the lenders were middle-class Americans who knew little or nothing about Puerto Rico, but simply opted for one of the many tax-exemptmunicipal bond funds that have become popular.
Such funds have appeared to offer both low risk and a tax shelter. They have long catered to residents of higher-tax jurisdictions, like New York City, San Francisco and Philadelphia, where people pay three layers of income tax, to federal, state and local authorities. In other places, like Maryland and Indiana, the local income taxes are paid to counties, not cities, which makes them harder to escape.
For tax-weary residents, bonds issued by United States territories and commonwealths offer a unique way to avoid these taxes lawfully. Investors who buy these 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. 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.
Puerto Rico has been making pacts like that for years, locking up more and more of its resources to secure more and more bonds. That made them easier to sell, which in turn reduced borrowing costs at the outset. But over the long term, it left less and less money to provide essential government services.
“This is the main problem with the muni market,” said Matt Fabian, a partner at Municipal Market Analytics. “We don’t worry, generally, about how bond proceeds are spent. We worry about how bonds are repaid.”
In 2006, for example, the Puerto Rico government created an independent debt-issuing authority called Cofina, which had first claim to a fixed portion of all sales taxes on the island, to offer as collateral for bonds. That meant less sales taxes for public services, and, after issuing nearly $15 billion of bonds, Cofina had exhausted its capacity — and Puerto Rico still had to borrow.
The 2008 financial crisis hit the island hard, and even though the government sharply cut spending, laying off tens of thousands of public workers and privatizing marquee properties like the Luis Muñoz Marín International Airport in San Juan, tax revenue fell even faster. The government filled budget holes by issuing more bonds.
“You can do that for a short time, but you can’t do that forever,” Mr. García Padilla said in an interview last week.
As the borrowing expanded, the island searched for more revenue streams to pledge as security for the bonds. Complicated deals were struck in which the Government Development Bank — the government’s fiscal agent — used one arm of the government to borrow on behalf of another, making it hard to be sure whose obligation the bonds really were. The tourist authority might borrow money, then send some of the cash to the electric authority, which used it to pay its bonds, while the touristHOTEL
projects languished. Years of maneuvers like that left less money available for the normal activities of government — like policing, staffing the public schools and providing clean water. But bondholders may not have sensed the crisis brewing because they still had pledges of collateral, lockbox arrangements and other recourse measures available to make sure they were paid.
Government spending and debt service became a Rubik’s cube of interrelated, crisscrossing payments. In 2012, Moody’s decided to solve the puzzle and found there were about $10 billion more bonds outstanding than it had counted before. It also reported that the island had issued $1.1 billion of bonds the previous year, of which $850 million bought no lasting public works but just serviced existing debt and plugged budget holes.
In May, Puerto Rico made the remarkable announcement that its main pension system was down to just seven-tenths of a penny for every dollar the retirees are due. A properly funded pension system has 100 cents on the dollar. It is not clear how the pension system is paying retirees, but when its remaining seven-tenths of a penny is spent, it will become a pay-as-you-go system, with hundreds of millions of dollars of new claims on the central government.
Mr. García Padilla did not make his debt restructuring plans explicit in his televised speech, but he did say he was “guaranteeing our citizens essential services and our pensioners a just income.”
That could mean that at least some of the bond security measures will be tested. Puerto Rico and its advisers set up the lockbox system, where the government must deposit its general-obligation bond payments several months in advance. Those payments are now costing the island $92 million a month.
Lawmakers in Puerto Rico are working on legislation that would authorize the suspension of those payments. But if the payments cease, general-obligation bondholders will sue. And if they sue, other types of creditors may sue to protect their interests. And because Puerto Rico is a commonwealth, it has no way to seek shelter in bankruptcy court, where the judge could stay all creditor lawsuits. 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.
Puerto Rico’s governor, saying he needs to pull the island out of a “death spiral,” has concluded that the commonwealth cannot pay its roughly $72 billion in debts, an admission that will probably have wide-reaching financial repercussions.
The governor, Alejandro García Padilla, and senior members of his staff said in an interview last week that they would probably seek significant concessions from as many as all of the island’s creditors, which could include deferring some debt payments for as long as five years or extending the timetable for repayment.
“The debt is not payable,” Mr. García Padilla said. “There is no other option. I would love to have an easier option. This is not politics, this is math.”
It is a startling admission from the governor of an island of 3.6 million people, which has piled on more municipal bond debt per capita than any American state.
A broad restructuring by Puerto Rico sets the stage for an unprecedented test of the United States municipal bond market, which cities and states rely on to pay for their most basic needs, like road construction and public hospitals.
That market has already been shaken by municipal bankruptcies inDetroit; Stockton, Calif.; and elsewhere, which undercut assumptions that local governments in the United States would always pay back their debt.
Puerto Rico’s bonds have a face value roughly eight times that of Detroit’s bonds. Its call for debt relief on such a vast scale could raise borrowing costs for other local governments as investors become more wary of lending.
Perhaps more important, much of Puerto Rico’s debt is widely held by individual investors on the United States mainland, in mutual funds or otherINVESTMENT accounts, and they may not be aware of it.
Puerto Rico, as a commonwealth, does not have the option of bankruptcy. A default on its debts would most likely leave the island, its creditors and its residents in a legal and financial limbo that, like the debt crisis in Greece, could take years to sort out.
Still, Mr. García Padilla said that his government could not continue to borrow money to address budget deficits while asking its residents, already struggling with high rates of poverty and crime, to shoulder most of the burden through tax increases and pension cuts.
He said creditors must now “share the sacrifices” that he has imposed on the island’s residents.
“If they don’t come to the table, it will be bad for them,” said Mr. García Padilla, who plans to speak about the fiscal crisis in a televised address to Puerto Rico residents on Monday evening. “What will happen is that our economy will get into a worse situation and we’ll have less money to pay them. They will be shooting themselves in the foot.”
With some creditors, the restructuring process is already underway. Late last week, Puerto Rico officials and creditors of the island’s electric power authority were close to a deal that would avoid a default on a $416 million payment due on Wednesday.
With other payment deadlines looming, Mr. García Padilla and his staff said they would begin looking for possible concessions on all forms of government debt.
The central government must set aside about $93 million each month to pay its general obligation bonds — a crucial action in Puerto Rico because its constitution requires such bonds to be paid before any other expense. No American state has restructured its general obligation debt in living memory.
The government’s PublicFINANCE Corporation, which has issued bonds to finance budget deficits in the past, owes $94 million on July 15. The Government Development Bank — the commonwealth’s fiscal agent — must repay $140 million of bond principal by Aug. 1.
“My administration is doing everything not to default,” Mr. García Padilla said. “But we have to make the economy grow,” he added. “If not, we will be in a death spiral.”
A proposed debt exchange, where creditors would replace their current debt with new bonds with terms more favorable to Puerto Rico, signals a significant shift for Mr. García Padilla, a member of the Popular Democratic Party, who was elected in 2012. His party is aligned with the Democrats on the mainland and favors maintaining the island’s legal status as a commonwealth.
He said that when he took office, he tried to balance the fiscal situation through austerity measures and fresh borrowing. But he saw that the island was caught in a vicious circle where it borrowed to balance the budget, raised the debt and had an even bigger budget deficit the next year.
Residents began leaving for the mainland in droves, and Puerto Rico’s credit was downgraded to junk, making borrowing extremely expensive.
Only a few months ago, the administration was considering borrowing as much as an additional $2.9 billion, which would be paid for by a fuel tax.
But recently, Mr. García Padilla’s team has been laying the groundwork for more drastic action. The governor commissioned a study of the financial situation by former officials at the International Monetary Fund and the World Bank. Concluding that the debt load is unsustainable, the report suggests a bond exchange, with the new bonds carrying “a longer/lower debt service profile,” according to a confidential copy reviewed by The New York Times. The García Padilla administration made the report public on Monday.
“There is no U.S. precedent for anything of this scale or scope,” according to the report, one of whose writers was Anne O. Krueger, a former chief economist at the World Bank and currently a research professor at the School of Advanced International Studies at Johns Hopkins University.
The “Krueger Report,” as it is being called, also seems aimed at the Obama administration and Congress, both of which have taken a largely hands-off approach to Puerto Rico’s fiscal problems. United States Treasury officials, however, have been advising the island’s government in recent months amid the worsening fiscal situation.
In June, Puerto Rico hired Steven W. Rhodes, the retired federal judge who oversaw Detroit’s bankruptcy case, as an adviser. The government is also consulting with a group of bankers from Citigroup who advised Detroit on a $1.5 billion debt exchange with certain creditors.
In Washington, the García Padilla administration has been pushing for a bill that would allow the island’s public corporations, like its electrical power authority and water agency, to declare bankruptcy. Of Puerto Rico’s $72 billion in bonds, roughly $25 billion were issued by the public corporations.
Some officials and advisers say Congress needs to go further and permit Puerto Rico’s central government to file for bankruptcy — or risk chaos.
“There are way too many creditors and way too many kinds of debt,” Mr. Rhodes said in an interview. “They need Chapter 9 for the whole commonwealth.”
Hedge funds holding billions of dollars of the island’s bonds at steep discounts are frustrated that the government has not seemed willing to reach a deal to borrowMORE MONEY from them.
“We want to be a part of the solution to the commonwealth’s fiscal challenges,” a group ofINVESTMENT firms, including Centerbridge Partners and Monarch Alternative Capital, wrote in a letter last week.
An aide to the governor said the hedge funds’ debt proposal was too onerous. And the deal would only postpone Puerto Rico’s inevitable reckoning.
“It will kick the can,” Mr. García Padilla said. “I am not kicking the can.”
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