Why you can’t ignore Puerto Rico’s bankruptcy

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It’s unknown how much debt will be included in the filing and how much creditors can get back. Video provided by Newsy Newslook

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Puerto Rico’s bankruptcy is poised to bludgeon investors, threaten the livelihood of American citizens who planned their retirement on the island’s promises, and undermine state governments.

The bankruptcy may also provide hope of fiscal sustainability and improved services for Puerto Rico, as the U.S. territory attempts to dig out of $74 billion in debt and $49 billion in pension promises.

But the ripple effects remain shrouded in uncertainty as the U.S. judicial system runs, for the first time, a debt-cutting legal process known as Title III of a 2016 law dubbed the Puerto Rico Oversight, Management and Economic Stability Act (PROMESA).

“Nobody really knows exactly what’s going to happen,” S&P Global Ratings credit analyst David Hitchcock said. “It’s highly uncertain.”

To be sure, the legal process is similar to the Chapter 9 municipal bankruptcies of Detroit in 2013 or Orange County, Calif., in 1994.

An oversight board governing Puerto Rico will aim to negotiate debt-cutting deals with creditors with the goal of achieving a viable “plan of adjustment” that a federal judge deems reasonable and fair.

But previous municipal bankruptcies have demonstrated that the clash between Wall Street creditors, mom-and-pop vendors, retirees, politicians, union officials and special interests is a recipe for inertia.

“I don’t know that a dawn is coming, but it’s going to get darker,” Municipal Market Analytics analyst Matt Fabian said in an interview.

What’s clear, however, is that in the absence of action Puerto Rico’s downward spiral will continue, as the island’s economy remains distressed and as thousands of people flee to the mainland.

To many Americans, Puerto Rico is a vacation spot and nothing more. But this bankruptcy could hit closer to home than they realize. Here’s why.

Fellow American citizens could continue to suffer.

Puerto Ricans are American citizens. They are suffering under the weight of heavy debt, government bureaucracy, high taxes and poor access to economic opportunity.

This bankruptcy may lead to their pensions and health care insurance taking hits, while services could also suffer cuts. Fabian estimated that some pensioners may get cuts of up to 20%.

But that may be necessary to help stabilize the island. Puerto Rico has lost 20% of its jobs since 2007 and 10% of its population, sparking an economic crisis that worsens by the day.

Still, without action to improve services such as public safety, health and education, the island’s population loss could continue or even accelerate.

Your retirement investments may take a hit.

Since Congress voted 100 years ago to exempt Puerto Rican bonds from federal, state and local taxes, those investments have attracted many people seeking tax-free retirement income.

Despite years of trouble, more than 40% of U.S. municipal bond funds still have exposure to Puerto Rico debt, totaling $7.82 billion in holdings, according to Morningstar data provided to USA TODAY.

What’s more, U.S. mutual funds hold about $8.38 billion in Puerto Rico debt, according to Morningstar.

Those bonds could be subject to steep cuts in bankruptcy, and while insurance may cover some of those losses, anyone who bet their portfolio on Puerto Rico should be nervous.

The bankruptcy “could have the advantage of a potentially global solution that might arrive more quickly and with lower legal costs, but it also strengthens Puerto Rico’s protection against legal claims,” Hitchcock said in a research bulletin.

It might be more expensive for your state to borrow.

Puerto Rico’s crisis shows that large governments can reach a point of no return, endangering investment principal.

That may give investors pause before they acquire debt from cash-strapped states and cities, Fabian said. That could increase borrowing costs for state and local governments, which must cut spending or raise taxes to make up the difference.

“I think it will make life more difficult in places like Illinois and New Jersey and Connecticut, where investors are already reluctant to loan the government money,” Fabian said. “It’s going to increase investor trepidation.”

The case could lead to a political eruption in Washington.

Although Washington’s response to Puerto Rico’s action was largely muted Wednesday — it was, after all, not unexpected — the unintended consequences of PROMESA may soon trigger a political firestorm.

If and when discussion of pension cuts heats up, expect angry missives from members of Congress — perhaps even from lawmakers who voted to create this debt-cutting process in the first place. Others may be upset about bondholders taking cuts.

“Members of Congress have a variety of interests in what sacrifices are made in this restructuring,” said Melissa Jacoby, a University of North Carolina professor and expert on municipal bankruptcy.

But don’t expect a bailout anytime soon. President Trump has blasted the possibility of rescuing Puerto Rico, and it’s highly unlikely Republicans on Capitol Hill will show any interest.

Follow USA TODAY reporter Nathan Bomey on Twitter @NathanBomey.


5 Things Every American Should Know About Puerto Rico’s Financial Crisis

Puerto Rico Gov. Alejandro García Padilla finally admitted defeat on Sunday, telling The New York Times that the island could not pay its massive $72 billion debt. Instead of taking on another round of high-interest borrowing to delay the inevitable default, he said it’s time for Puerto Rico’s creditors to “share the sacrifices” that the island’s residents have already had to bear.

In light of that major development, here are five key reasons why every American should care about what’s going on in Puerto Rico. An earlier version of this article was published in May.

1. All Puerto Ricans are Americans, really.

puerto rico american flag

People wave flags as President Barack Obama’s motorcade drives past during a visit to San Juan, Puerto Rico, on June 14, 2011. (Photo: Saul Loeb/AFP/Getty Images)

You might not guess from the amount of media attention the island receives on the mainland — or from how often the mainland media incorrectly refers to Puerto Ricans living in the states as “immigrants” — but everyone born on the island is an American citizen and holds a U.S. passport. However, the 3.7 million Puerto Ricans currently living on the island aren’t eligible to vote for president — just those who have moved to one of the 50 U.S. states.

Like many of their fellow Americans, Puerto Ricans have been vocal in their opposition to balancing budgets on the backs of the poor and middle classes. Earlier this year, throngs of students hit the streets of San Juan to protest García Padilla’s proposal to cut some $166 million from the island’s public university system — roughly one-fifth of the system’s total budget. The drop in education funding was among the most controversial in a series of deep cuts to Puerto Rico’s budget and emblematic of the extreme austerity measures pushed to handle the spiraling debt crisis.

2. Congress could easily address this situation, but hasn’t.

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President Obama eats a “medianoche” sandwich with Alejandro García Padilla, the future governor, at Kasalta Bakery in San Juan on June 14, 2011. (Photo: Saul Loeb/AFP/Getty Images)

Legislation to help Puerto Rico get out from under its debt burden has been proposed in Congress by Resident Commissioner Pedro Pierluisi, the island’s non-voting representative. The Puerto Rico Chapter 9 Uniformity Act would allow the island’s municipalities and public corporations to declare bankruptcy and restructure their debts under Chapter 9 — something that the cities and towns of all 50 states already can do. But many members of Congress oppose the move as a bailout, even though it would not cost the federal government.

Absent an act of Congress, the Federal Reserve is prohibited from lending Puerto Rico money. U.S. Treasury officials and the White House have publicly ruled out aid packages to save the island’s government from default, instead advising Puerto Rican officials to just keep searching for “credible” financing plans.

On Monday, the White House reiterated its anti-bailout position, although it did urge Congress to explore extending financial relief to the island by extending Chapter 9.

3. Americans on the mainland hold Puerto Rico’s debt.

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Some of the biggest stakeholders in Puerto Rico’s financial crisis can be found on the U.S. mainland.

The island’s municipal bonds have been widely traded in U.S. markets due to their triple tax-exempt status — exempt from federal, state and local taxes, they’ve been an attractive bet for long-term investors. Despite the growing economic instability and the rumblings of a potential default, investment banks and hedge funds have continued to view Puerto Rico that way.

Last year, the island sold some $3.5 billion in municipal bonds even though they were given junk status — the largest junk-rated municipal offering in history, according to Bloomberg. And earlier this year, Goldman Sachs’ asset management division boosted its stake in Puerto Rico’s government-run power company, PREPA, from $351 million to $1.3 billion.

4. Puerto Rico matters for 2016. Just ask Jeb Bush.

jeb bush puerto rico

Former Florida Gov. Jeb Bush speaks during a town hall meeting with Puerto Rico’s Republican Party in Bayamon on April 28, 2015. (AP Photo/Ricardo Arduengo)

Visiting Puerto Rico is widely viewed as a way to shore up support among the mainland’s increasingly powerful Latino vote. While island residents can’t vote for president, nearly 5 million Puerto Rican-born and -descended people live in one of the 50 states, and they enjoy the right to vote. An increasing number of Puerto Ricans are concentrated in the swing state of Florida.

So it’s no surprise that former Florida Gov. Jeb Bush (R) visited the island earlier this yearon a fundraising trip, during which he openly endorsed giving Puerto Rico access to bankruptcy protections. While in South Carolina on Monday, Bush again spoke favorably about allowing Puerto Rican municipalities and public corporations to declare bankruptcy, though he also raised conditions.

“I think if Puerto Rico can make a compelling case that they’re prepared to alter the social contract with their extraordinarily large number of state workers and in return for allowing for a reduction, you know, dealing with the debt load that’s unsustainable, where they can start growing economically again — they’d have to do all three of those things at once — then giving them that flexibility would be important,” Bush told reporters. “That’s why I’ve suggested it about a month ago. I think Puerto Rico has a responsibility now to come up with a plan that makes it serious, a serious plan that people could look at.”

Democratic presidential hopeful Hillary Clinton also has plans to visit the island this year, according to Puerto Rican daily El Nuevo Día.

5. What’s happening in Puerto Rico reflects the wider evisceration of the American middle class.

puerto rico economy

A demonstrator paints a sign on the street that reads in Spanish, “Let the rich pay,” during a protest outside the hotel where former Gov. Luis Fortuno meets with foreign investors in Fajardo, eastern Puerto Rico, on Oct. 22, 2009. (AP Photo/Andres Leighton)

While Puerto Rico’s economic situation is more serious than that of the 50 U.S. states, its problems should sound familiar: contraction of the manufacturing sector, weaker job security, difficulty in reversing unemployment, loss of public services and middle class decline.

And if certain mainland politicians have their way, Puerto Rico’s plight might grow even more familiar. In the past, conservatives on the national stage have touted the island’s push toward austerity as a model for making small government work.

CORRECTION: An earlier version of this story misstated the status of Puerto Rico’s municipal bonds. They are triple tax-exempt in the U.S. — that is, exempt from federal, state and local taxes.


Puerto Rico declares bankruptcy. Here’s how it’s going to unfold

Puerto Rico’s financial oversight board has filed a form of bankruptcy for the island under Title III of last year’s Puerto Rico rescue law, which is known as PROMESA. USA TODAY

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Facing mountainous debt and population loss, the board overseeing Puerto Rico filed Wednesday for the equivalent of bankruptcy protection in a historic move that’s sure to trigger a fierce legal battle with the fate of the island’s citizens, creditors and workers at stake.

The oversight board appointed to lead the U.S. territory back to fiscal sustainability declared in a court filing that it is “unable to provide its citizens effective services,” crushed by $74 billion in debts and $49 billion in pension liabilities.

The filing casts a shadow of uncertainty over the future of Puerto Rico pensioners, American retirees who own the island’s debt, institutional investors who backed the island in good times and businesses with lucrative contracts.

But it could also provide hope to residents seeking to preserve access to basic services such as public safety and health care, while also offering a potential route to economic stability for an island that has been suffering for years. Puerto Rico officials have complained that their debt crisis has cut off funds needed to pay doctors and run schools.

Puerto Rico has lost 20% of its jobs since 2007 and 10% of its population, sparking an economic crisis that worsens by the day.

The island’s response has worsened matters. Politicians raised taxes, allowed governmental bureaucracy to balloon, borrowed to pay the bills and promised pensions that the island could not afford.

“The result is that Puerto Rico can no longer fully pay its debt and pay for government services,” the oversight board said in the court filing. “Nor can Puerto Rico refinance its debt — it no longer has access to the capital markets. In short, Puerto Rico’s crisis has reached a breaking point.”

The island’s slumping economy was, perhaps, the final straw. Some six in 10 Puerto Ricans are unemployed or not interested in working, and nearly half are enrolled in Medicaid.

Puerto Ricans are U.S. citizens and can move to the mainland at any time, draining the island’s tax base. Tens of thousands have streamed into Florida.

The legal case is not technically considered a bankruptcy filing under the federal code that governs municipal cases, but it’s similar. Instead, it was filed through a bankruptcy-like mechanism dubbed Title III of legislation authorized by Congress and signed into law by President Obama in 2016.

Here are key questions:

What happens next?

U.S. Supreme Court Chief Justice John Roberts will appoint a life-tenured judge, likely a U.S. District Court judge, to oversee the case, said Melissa Jacoby, a University of North Carolina law professor and expert on municipal bankruptcy.

That’s different than Chapter 9 municipal bankruptcy cases, where a bankruptcy judge controls the process.

The person appointed to oversee the case will have significant power over how it unfolds.

This particular debt-cutting process has never occurred, so the lack of legal precedent could leave the judge with much sway over the future of Puerto Rico.

What does the oversight board do?

The oversight board will aim to negotiate debt cuts with creditors, after which it will propose a plan of adjustment. The judge will decide whether to authorize the plan, which could lead to massive debt cuts.

How will investors be treated?

They’re in trouble.

To be sure, it depends on the status of their debt. If they hold secured bonds, they might get paid in full. But unsecured bondholders could suffer significant cuts, depending on which types of debt the judge determines to be vulnerable.

Financial creditors, including major investors that had bet on Puerto Rico bonds that were exempt from federal, state and local taxes, argue that their investments were made when the island was not eligible for bankruptcy.

But Congress passed the Puerto Rico Oversight, Management and Economic Stability Act (PROMESA) specifically to create a process that allows the island’s numerous debt-saddled governmental entities to achieve debt relief.

Complicating matters is the various governmental entities included in the bankruptcy filing, each of which has its own investors and creditors wanting to be paid.

“It really isn’t clear how creditors stack up against each other,” Jacoby said.

Moody’s Investor Service Vice President Ted Hampton concluded Wednesday that the bankruptcy filing is actually “a positive step for bondholders overall” because it will bring about “orderly process that should be better for creditors in the aggregate than a chaotic and uncertain period involving proliferating lawsuits.”

What happens to Puerto Rico pensioners?

They might face cuts because Puerto Rico has run out of pension funds.

In the Chapter 9 bankruptcy of Detroit, retirees agreed to accept cuts after a federal judge ruled that their pensions could be cut in municipal bankruptcy. That could pave the way for a similar ruling in Puerto Rico.

The PROMESA law states that the oversight board must identify a fiscal plan that will “provide adequate funding for public pension systems.”

Puerto Rico pensioners also have certain legal protections, but inside of bankruptcy those protections can collapse. That’s exactly what happened in Detroit.

That’s why pension cuts and reductions to health care insurance could be in the cards.

But pensioners may still fare better than investors, Municipal Market Analytics analyst Matt Fabian suggested Tuesday in a research note. That’s because pensioners are more politically empathetic than Wall Street creditors and bond insurers.

Could Puerto Rico sell off assets to pay some debts?

That’s possible. In Detroit, which had $18 billion in debt, the city faced pressure from creditors and pensioners to consider selling off the city-owned Detroit Institute of Arts. The city instead negotiated a deal to avoid liquidating art and collected an infusion of cash from private donors and the state of Michigan.

The city could not be forced to sell assets because Chapter 9 bankruptcy prevents federal judges from ordering municipalities to take such actions.

Similarly, PROMESA dictates that the court may not “interfere with” the island’s “property or revenues,” without the oversight board’s consent.

So a judge may not be able to order the island to sell off beachfront property.

But that doesn’t mean creditors won’t try to pressure the island into it.

“I wouldn’t be surprised because we’ve seen it in other contexts,” Jacoby said.

Follow USA TODAY reporter Nathan Bomey on Twitter @NathanBomey.

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