Op-ed: Default: Puerto Rico's Inevitable Option

Originally published by Forbes here.

Washington politicos aren’t the only ones instigating a perpetual debt crisis.  Puerto Rico too is experiencing a political stalemate-induced fight for their financial lives that affects not only its 3.7 million residents, but millions of others who have purchased bonds to help finance its government, causing us to wonder if the next logical step is a debt default.

Some Painful Facts

With triple tax exemption (federal, state, and local), combined with higher-than-average yields, Puerto Rican bonds became so popular in recent years that it was able to rack up $70 billion of debt now held by institutional investors and mutual funds alike.  The debt-to-GDP ratio is now nearly 70% and growing, not including pension obligations, which raises the ratio to over 90%. With a per capita debt load of $19,000 and growing, Puerto Ricans shoulder almost 4 times the burden of U.S. leader Massachusetts which carries a deficit of $5,077 per citizen. Even the fiscally retarded number three ranked Illinois shows only a per capita load of $2,539. For another vista California, with $97.6 billion in absolute debt has a population about ten times that of Puerto Rico but only carries 1.4 times the debt. A seemingly perpetual recession has enshrouded this island paradise for the last eight years which has seen its economy contract by over 16%. If you don’t get it yet, Puerto Rico has entered a debt vortex that is inexorably sucking the life from its economy and its continuously shrinking populace.The 2013 deficit was around $2.2 billion. A $9.8 billion budget was approved for fiscal year 2014, with a still significant deficit of nearly $300 million. Some investors expect the shortfall to be as much as $800 million. Puerto Rico will have no choice but to answer in typical American fashion:  finance debt with more debt. But will investors answer the call to, in my opinion, throw good money after bad?Many experts say Puerto Rico is entering the eighth year of a recession, with at least one who considers it to be in the midst of an all-out depression.  Gustavo Vélez, former economic adviser to the Governor, is one such analyst, acknowledging that the economy has been kept afloat by increasing taxes, with little or no effort to fix underlying structural problems.Some reforms have been enacted with the recent passage of a pension reform bill and the relatively bold 2014 budget. (Pensions are only 7 percent funded). The fix will again fall short, with substantial tax increases (another $1 billion) and a dash of restructuring (a mere $575 million of restructured bond debt, equal to less than 1% of total debt, and a reduction of $600 million in pension contributions) that offers little incentive for economic growth.A government shutdown (sound familiar?) brought Puerto Rico to the brink of default in 2006, so the government passed its first sales tax.  In 2009, under a new administration, payroll tax reduction and regulatory reform hoped to incent new growth.  The Governor even reduced the overall corporate tax rate and fired tens of thousands of government employees, ideas mocked by Democrats in Washington.  All of which contributed to debt reduction and a light, albeit a dim one, at the end of the tunnel.Nonetheless, new taxes couldn’t be avoided.  When little growth ensued, bondholders and rating agencies again applied the pressure to increase revenues, leading to a new tax on foreign corporations, the one stable group of taxpayers Puerto Rico can’t afford to scare away.  Puerto Rico has long been a hub for American and international pharmaceutical manufacturing, but fears of another round of tax increases combined with looming patent expirations are forcing one of the island’s most reliable sectors to reconsider its presence in the Caribbean. A 2006 repeal of IRS rule 936 which exempted Puerto Rican subsidiaries from Federal income tax was the first wheel to fall off. In 2011 a 4% excise tax on corporations hastened the exodus. Teva, (TEVA) Merck (MRK), Bristol Myers Squibb (BMY), and Actavis (ACT) are all giant pharmaceuticals that have either closed and/or announced they will be leaving the island altogether. Manufacturing jobs have contracted over 30 percent since 2006.Gustavo Vélez thinks Puerto Rico will continue to meet its sales tax, general obligation, and other bonds in the short-term.  But in the long-term his opinion shifts.  In order to avoid a forced default, politicians are going to have to risk their jobs by making decisions that voters aren’t going to like.  A creative and substantial economic plan that combines tax incentives to attract investment and regulatory reform to streamline it will be necessary to counter a welfare state so dependent on transfer payments from the U.S. that only 40% of eligible workers are even trying to work. On top of this there is only 41 percent labor force participation rate. (The U.S. is 63 percent down from more normal levels of 66 to 67 percent.) Food Stamps, or NAP or Nutritional Assistance Program as they are euphemistically referred to in Puerto Rico, were over $2 billion for 2012 and as many as one third of the island’s population availed themselves to this accoutrement. Over all, including Section 8 Housing, Head Start, Social Security, disability, VA benefits, Medicare, Medicaid, and others, the mainland in 2012 contributed $21.8 billion or over 21% of Puerto Rico’s slightly greater than $100 billion economy.With $70 billion in debt outstanding – let’s estimate an average 3 percent coupon – then $2.1 billion or over 20 percent of the budget would go to service debt. As Puerto Rican bonds have fallen so much in price they now yield above 9 percent in many cases, so refinancing maturing debt at these levels would be crippling. If Puerto Rico was forced to issue new debt at 9 percent, it wouldn’t be too long before debt service would start to eat up 30, 40, or even 50 percent of its budget…….not too unlike the scenario in mainland America should rates spike by several hundred basis points.Other FactorsAt over 29 cent per kilowatt hour Puerto Rico has double the average electricity costs of the rest of the US. Powerful unions make meaningful pension reform difficult.  The last reform was fought all the way to territory’s Supreme Court, makings this option politically dangerous if not unfeasible.  Privatization of state-owned firms, like the Puerto Rico Electric Power Authority (PREPA), would offer some relief with better management and a reduction in the high energy prices. Politicians don’t seem interested in tackling these issues head on. Perhaps they realize the inevitable and believe that devaluing bonds will make it easier to significantly restructure them.  Or maybe they are just apathetic financial managers more interested in saving their political careers than making structural changes.Bankruptcy, Default, and Investors and Moral HazardThis past July Detroit filed the largest Chapter 9 municipal bankruptcy in U.S. history. As the judge sorts out fire and police pensioners’ claims versus creditors’, some eyes are shifting south and wondering whether this may be a template for what happens in Puerto Rico. It is clear that the current business model is unsustainable and default or restructure is not if, but when. Restructure to avoid bankruptcy would imply an agreement by bondholders to take a principal haircut usually with some demonstration of fiscal reform or an increase in collateral. A voluntary restructuring like this is unlikely given the vast numbers of bondholders and their disparate opinions to achieve their goal of getting paid back.Since there doesn’t seem to be the political will to reform the economy, in my opinion, some sort of bankruptcy scenario is inevitable. And the sooner the Band-Aid is ripped off the better. The big pushback will be from all the literally hundreds of mutual funds that hold Puerto Rican bonds. Oppenheimer funds hold almost $5 billion of “paper” or 14 percent of total holdings. Franklin Templeton group of funds owns over $4.8 billion, which represents 6.5 percent of overall positions.These and other firms may push for some sort of bailout or invent some new reprieve for beleaguered Puerto Rico. The Obama Administration too will be tempted to woo the nearly four million potential Democrat voters into their good graces with another option:  the cushy bailout.  Politically, there’s about as much chance of this happening as there is Boehner and Obama enjoying cocktails together on weekends.  Bailouts, however, aren’t always comprised of direct cash injections and the Obama Administration has proven its adroitness in finding behind-the-scenes alternatives.It would be interesting to know if Dodd-Frank has any language prohibiting financial assistance for municipalities. These mutual funds must simply be responsible, take their lumps, and do better homework next time. In fairness though, any municipal fund that indexes in any way, by definition, would be required to hold Puerto Rican bonds in their portfolios.Puerto Rico has to restructure.  They can’t keep borrowing at 8 and 9%, raising taxes on the only ones paying any, and chasing away its brightest contributors to the relative economic paradise of the mainland.  Bondholders have already taken a big hit and are going to take a long, slow and inevitable bigger one if they don’t restructure now.Even if there is a bankruptcy, and even if bondholders get 30 or 40 or 60 cents on the dollar and even if pension obligations are reduced 30 or 40 percent, Puerto Rico must undergo an economic structural reform and create a competitive economy that incentivizes new business and creates an atmosphere that that makes it more profitable to work than to be on the dole. With 13.9 percent current unemployment and 25 percent of the workforce employed by the government the kind of change needed requires a change in ethos……a change in attitudes by the populace from being dependent on the government to being much more independent and self-reliant. Effectively a suzerainty of America, Puerto Rico is encumbered with the welfare state mentality that discourages work, much less innovation. Subsistence on the largesse of America is now endemic to the psyche of the populace…..and once established, it is a cycle nearly impossible to break.Some giant bond funds, think PIMCO and Blackrock (BLK), predict tumult for the markets if Puerto Rico defaults or if Fitch downgrades bonds to junk status. Puerto Rico is less than 2 percent of the total municipal market. There might be some bumps but this is not a falling rock that will start a landslide. The truth is, Puerto Rican debt is junk and should have been rated as such long ago. In my opinion, it is but one more example of disingenuous behavior on the part of our rating agencies. Think Washington knows a thing or two about kicking the can down the road?  Puerto Rico could teach a class.

Justin Vélez-Hagan is executive director of The National Puerto Rican Chamber of Commerce, economic policy researcher at the University of Maryland-Baltimore County, and author of the upcoming book, Nousonomics: The Common Sense behind Basic Economics.