Puerto Rico’s Financial Crisis Avoided---For Now
Headlines in the financial press seem to indicate that Puerto Rico’s massive debt issue priced on March 11th was a success. Originally planned to be a $3 billion offering, reports have indicated that the deal was met with great enthusiasm by investors as orders for the bonds totaled $16 billion. Demand was so strong that Barclays PLC (BCS), Morgan Stanley (MS) and RBC Capital Markets, the main underwriters, were able to increase the amount of the deal by $500 million. Moreover, once the bonds were free to trade, their value rose by as much as 7.5%, a substantial percentage for a fixed-income security.
The fact remains, however, that Puerto Rico’s problems are far from resolved. Still faced with a weak economy and a crushing debt burden, the proceeds from the new debt issue have only granted the island a temporary reprieve. According to estimates, the commonwealth only has sufficient cash to fund operations through fiscal 2015.
For years, brokerage firms have been marketing Puerto Rico bonds to the retail market as a safe investment. Now that the bonds no longer carry an investment grade, the underwriters intentionally bypassed traditional participants in the tax-exempt market. Instead, the debt was aggressively pitched to very large alternative investors such as hedge funds and taxable junk bond investors. In addition, there were rumors that $50 million was the “recommended” minimum order.
“Is Puerto Rico the Next Detroit?” Or perhaps, “Puerto Rico, America’s Greece”. These are just two of the headlines that investors may have seen recently and breezed past since they didn’t believe they had any exposure to the issue because they didn’t own Puerto Rico bonds. However, the size and breadth of the problem may have effects that go far beyond the municipal debt market.
What exactly is the problem? Well it starts with the island’s economy. Even in the best of times, Puerto Rico is not prosperous. In fact, if it was a state, it would be significantly poorer than Mississippi, the nation’s least well off state. Add in years of financial mismanagement by government officials and investors’ insatiable appetite for the commonwealth’s bonds, and the result is the situation that we have today. Years and years of unbalanced budgets.
The issues goes much further than the size of the economy, however. The real crisis is the amount of debt that has been issued compared to the size of the population. The numbers are startling. With a population of only 3.5 million inhabitants, Puerto Rico has direct and indirect debt outstanding of approximately $70 billion. Only California and New York can claim to be bigger borrowers.
Puerto Rico’s liquidity problems did not happen overnight. It took a long time to dig itself into such a deep hole. Moreover, the situation occurred in plain sight for all to see, especially the major rating agencies, McGraw Hill Financial's (MHFI) Standard & Poor's, Moody’s (MCO), and Fitch (50% FIM:FP & 50% Hearst Corp. private). Indeed, for eight years, the island’s economy has been in a recession. Since 2006, Puerto Rico’s economy has contracted by 15%. The catalyst for the downturn was the expiration of generous tax breaks granted to manufacturers by the U.S. Congress. Corporations had previously been exempted from paying taxes on profits generated on the island. When originally enacted, these tax incentives caused a flurry of new factory construction on Puerto Rico, which provided a boost to the economy.
With no tax incentive to stay, corporations fled the island, taking with them relatively high-paying jobs. As a result, unemployment soared and still remains stubbornly high today at 15%, more than double that of the U.S. This also started a downward spiral. As the size of the economy declined, many of the island’s skilled personnel fled to the mainland. From 2010-2012, the population shrank 1.5%, leaving less tax revenue for the government and an increased demand for social services. Thus, instead of tightening the purse strings, the government went to the capital markets to finance their deficits.
Structural problems with the economy are also endemic. Only 41% of working age people participate in the work force, while one-quarter are employed by the government. This compares to the U. S. averages of 63%, and 15%, respectively. Moreover, Puerto Rico’s unfunded pension liabilities are staggering. Illinois has made headlines because only 40% of its pension liability is funded. The lowest of any state. By contrast, Puerto Rico’s pensions are only 11% funded.
With all of these red flags, surely the rating agencies took note, right? Unfortunately, the answer is no. The bonds remained on negative credit watch with a low investment grade rating for all of 2013. Just as the case with subprime mortgages, not until the crisis boiled over and the price of the bonds fell substantially, was Puerto Rico’s debt downgraded to junk status in February of 2014.
Why would municipal bond holders be so interested in Puerto Rico’s bonds over the years? The answer is the commonwealth’s special “triple tax exemption” status. This feature has been called “a rare and desirable trait”. This means that the income earned from these bonds is not just exempt from federal taxes, but also from all state taxes in all 50 states. Thus, an investor in the highest tax brackets from every state would find the yield attractive. For example, there are several high tax states such as Oregon, that don’t issue much debt. The robust demand for such state’s bonds can drive the yields to such low levels that investors turn to Puerto Rico obligations as an alternative.
Detroit was in economic trouble for some time before eventually filing for Chapter 9 bankruptcy last July. As Detroit floundered, more scrutiny fell on Puerto Rico and investors began selling their bonds at a furious pace. Rates on bonds rose from 5% to over 10%. Prices on long duration bonds declined by as much as 40%. Yields actually reached a higher level than Greece’s bonds. Puerto Rico bonds have actually rallied since the credit downgrade and the new deal was priced at 8.27%.
Unlike Detroit, Puerto Rico cannot file for bankruptcy. Puerto Rico is considered an American territory. Its citizens are subject to U.S. law, don’t pay federal taxes but also are not allowed to vote for President, nor do they have voting representation in the House of Representatives or the Senate. No mechanism exists for states or territories of the United States to pursue bankruptcy. Indeed, the U.S. territory of the Northern Marianas Islands attempted to declare bankruptcy, but was denied doing so by a US court. Moreover, Puerto Rico’s constitution gives bond holders preference to revenues. In Detroit, the financial custodian classified the city’s General Obligation bonds, which by law are supposed to have first claim on the city’s revenues, to be on par with other debts.
To be fair, Puerto Rico has been trying to mend its ways. The past two governors have enacted strict reforms, which have been very unpopular among the citizenry. Workers have been laid off from the bloated payrolls and some of the extravagant benefits previously allowed to employees have been reduced. (Some teachers had been able to retire as early as age 47.) Also, as would a troubled corporation, Puerto Rico has been selling or leasing assets to raise cash. Two and a half years ago, the government granted Goldman Sachs (GS - Free Goldman Sachs Stock Report) and the firm Abertis Infraestructuras S.A, a 40-year lease on two toll roads. Plans appear to be in the works to lease out the airport and other revenue generating operations.
Investors should also realize that the chances of any bailout by the federal government appear to be extremely slim. Detroit has been allowed to go bankrupt and several financially strapped states and municipalities would most likely raise strong objections, if Puerto Rico was assisted while they were not. Furthermore, with no votes at stake, the option doesn’t hold much appeal to politicians at this time.
Why should investors care if Puerto Rico can’t pay its debts? There are several reasons. First, with so much debt outstanding, the fixed income markets could easily be thrown into disarray, as was the case when problems with Greece’s debt arose and then spread to other emerging nations. Furthermore, just as Detroit’s problems led to the bond markets turning on Puerto Rico debt, the possibility exists that other states facing liquidity problems could face greater scrutiny and effectively be priced out of the market.
Maybe the biggest uncertainty involves potential lawsuits and penalties by regulators. Following the subprime debacle, almost every major brokerage house was sued by owners of the debt. Bank of America (BAC) has spent billions of dollars on legal fees in ongoing cases regarding mortgages sold by a mortgage originator that it acquired.
Last fall, the Secretary of State of Massachusetts launched an investigation into whether investors were made aware of the risks related to Puerto Rico credits. Letters were sent to Oppenheimer's Rochester Fund, which has a significant investment in Puerto Rico credits. Also receiving a letter was UBS AG (UBS) regarding its municipal closed end funds. Numerous other state Attorney Generals took note of these actions, no doubt. In addition, law firms have already set up websites for holders of these funds to contact them for litigation.
Others at risk are municipal bond funds and the large brokerage firms that underwrote the deals. (By one estimate, 70% of all municipal bond funds have some exposure to the commonwealth’s debt.) Critics have long claimed that the MSRB (Municipal Regulatory Rules Board), which regulates the municipal bond market and is overseen by the SEC, has long favored brokerage houses and debt issuers over the individual investor. Claims have been made that Puerto Rico has been tardy in meeting financial disclosure requirements (as many other municipal debt issuers have also been).
In sum, there is the potential for a plethora of lawsuits filed against any large brokerage firm that has ever issued Puerto Rico debt instruments. This could result in potential large fines and onerous legal settlements that could impact just about every major brokerage house. Corporations such as Goldman Sachs, Morgan Stanley, Bank of America, Barclays, and UBS, to name some, are all possible targets. And as we learned from the subprime disaster, lawyers seem to go after the targets with the most money no matter how tangentially they were involved.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned