Puerto Rico’s Debt Trap
The Issue:At the beginning of May, Puerto Rico entered an unprecedented form of bankruptcy protection with a record breaking $123 billion in combined debt and unfunded pension commitments. The ensuing restructuring process will be, in effect, the largest municipal bankruptcy ever, dwarfing Detroit’s $20 billion Chapter 9 filing in 2013. Because this process will be administered under a new law created specifically for Puerto Rico, which enjoys special status as a U.S. territory, there is significant uncertainty about how losses will be shared between bondholders, pension recipients, the island’s taxpayers and residents, and others.
The debt crisis in Puerto Rico has been brewing for many years and, regardless of outcome, the situation will continue to bring hardship to the island’s residents.
- Puerto Rico's status as a U.S. territory makes the outcome of its debt crisis particularly uncertain. Unlike U.S. municipalities, a U.S. territory cannot resort to the more familiar Chapter 9 of the Bankruptcy act, which has been used in previous municipal bankruptcies. The Commonwealth of Puerto Rico, on the other hand, is a territory of the United States. The island was under Spanish authority from 1493 to 1898, when it was claimed by the United States at the conclusion of the Spanish-American War. Since the 1917 Jones-Shafroth Act, Puerto Ricans have also been citizens of the United States. The population of Puerto Rico in 2016 was estimated at 3.4 million, with another 5 million Americans of Puerto Rican ancestry living in the mainland United States. Puerto Ricans, as United States citizens, enjoy the option to move with relative ease to the mainland, a fact that has led to a persistent “brain drain” that will complicate efforts to pay the island’s debt and restructure its economy. Although Puerto Rico is poor by the standards of the rest of the United States, the Commonwealth is an upper-middle income area by world standards. GDP per capita, at about $30,000 is close to that of nations like Italy and South Korea while at the same time being significantly lower than the GDP per capita of the rest of the United States, which is almost $60,000.
- The Puerto Rican economy was supported during most of the post-war period by two tax-related American policies. The first was a policy of corporate tax exemptions, which made the island an attractive location for manufacturing firms in sectors such as chemicals and pharmaceuticals. From 1976 to 2006, this exemption was implemented through Section 936 of the Internal Revenue Code, which allowed Puerto Rican subsidiaries of U.S. firms to avoid corporate income taxes if they distributed their profits as dividends. In 1996 President Clinton signed legislation phasing out this provision of the tax code, and the provision was fully repealed in 2006. The repeal of this tax incentive has been identified as one cause of the deep economic recession in the Puerto Rican economy that began in 2006 and has not abated.
- A second support for the island economy was a special tax exemption on the interest paid by the municipal bonds issued by Puerto Rico and by its agencies – an arrangement that facilitated borrowing. Municipal bond interest in the United States is generally exempt from federal taxation, but the situation with state and local taxation is more complicated. In general municipal bond interest will be tax-exempt for residents of the state in which the issuing authority is located, but an investor in Massachusetts, for example, will pay state income tax on bonds issued by Kentucky. Puerto Rican municipal debt, however, has enjoyed what has been called the “triple tax exemption”, meaning that for any resident of the United States the interest on this debt will be exempt from federal, state, or local taxes. This triple tax exemption has made Puerto Rican debt attractive for American investors. Many municipal mutual funds, for example, market themselves narrowly to investors within specific states because of the specificity of the state-level tax exemption. But the general tax exemption of Puerto Rican debt made it attractive for investment managers looking for high-yield tax-exempt assets, so this debt found its way into mutual funds that were explicitly labeled as being “California”, “Kentucky”, or otherwise.
- The period between 2006 and 2015 saw a rapid rise in the government indebtedness of Puerto Rican government authorities. The total bond indebtedness amounts to over $70 billion face value of debt, which was about 70 percent of the island’s GDP. The island owes an additional $50 billion in unfunded pension obligations to its state employees and retirees. Much of this increase in indebtedness appears to have been used to accommodate unresolved budget deficits that were run during that period of sustained economic contraction. Complicating the matter, the debt is issued by a panoply of different government-sponsored entities, and they often appear to represent different claims on the revenue streams that the Commonwealth and its authorities can pledge.
- Puerto Rican issuers were downgraded from investment grade status in 2014, and that downgrade represented an important signal – though not the first signal – to the market about the economic issues on the island. With that signal of increased risk, mutual funds and other investors who had held Puerto Rican debt sold much of their holdings to investors who were more comfortable with the island’s higher level of perceived credit risk – for example hedge funds. In March of 2015, then-governor Alejandro Garcia Padilla announced that the island’s debt was unpayable. Resolution has been delayed in part by disagreements between Puerto Rican government officials and holders of the Island’s debt about the borrowers’ capacity to repay debt. While some argued that the island was capable of paying its obligations to capital markets, others countered that some restructuring of the island's debt was necessary. With the passage of time, the crisis continued to deepen.
- In approximately simultaneous moves, Puerto Rico defaulted on its general obligation debt in June of 2016 and President Obama signed the “Puerto Rico Oversight, Management, and Economic Stability Act” (PROMESA) law, which created an oversight board with the authority to oversee the island’s budget and facilitate restructuring talks. The law also created a bankruptcy-like “Title III” mechanism. The oversight board placed a moratorium on debt collection by the island’s creditors until May 1, 2017, and on May 3 the island entered the debt restructuring process. Chief Justice John Roberts has assigned the case to U.S. District Judge Laura Taylor Swain, and the first hearing in that case is scheduled to occur on May 17.
What this Means:
It is difficult to forecast the outcome of this process. It will pit the interests of different classes of bondholders against each other and against the interests of the island’s taxpayers and residents. The need to keep schools, water systems, and electricity services functioning will, in all likelihood, turn out to be impossible to square with full repayment for the owners of different bonds issued by the island and its agencies. As Matt Fabian, a widely respected municipal analyst, said recently: “There just isn’t enough money. Nobody has any idea what is going to happen.”