New York Times
POSTED: 1:30 a.m. HST, Oct 8, 2013
While Detroit has preoccupied Americans with its record-breaking municipal bankruptcy, another public finance meltdown on a potentially greater scale has been developing off most Americans' radar screens, in Puerto Rico.
Puerto Rico has been effectively shut out of the bond market and is now financing its operations with bank credit and other short-term measures that are unsustainable in the long run. The biggest concern is that the territory, which has bonds that are widely held by mutual funds, will need some sort of federal lifeline, an action for which there is no precedent.
In a meeting with bond analysts in New York on Monday, the president of the Puerto Rican Senate, Eduardo Bhatia, said officials in the U.S. Treasury and White House had been analyzing the situation carefully, "wondering how they can help Puerto Rico send a very strong signal of stability right now."
"We are waiting for some sort of an announcement from the Treasury and the White House," he said without clarification. He also complained that analysts and investors did not appreciate the tough austerity measures that Puerto Rico pushed through in recent months.
Puerto Rico, with 3.7 million residents, has about $87 billion of debt, counting pensions, or $23,000 for every man woman and child. That compares with about $18 billion of debt for Detroit, with a little more than 700,000 people, or about $25,000 for every person in the city. Detroit and Puerto Rico have been rapidly losing population, leaving a smaller, and poorer, group behind to shoulder the burden.
Detroit, at least, was able to seek relief in bankruptcy court, but Puerto Rico is in a legal twilight zone. Territories, like states, have no ability to declare bankruptcy. Another territory, the Northern Mariana Islands, tried in 2012, but its case was rejected.
Top Puerto Rican officials say that the territory is not bankrupt and is working through its problems responsibly. To show their good intent, the governor, Alejandro Garcia Padilla, and members of his government have been shuttling to New York and Washington in recent weeks, meeting with bankers, credit analysts, members of Congress and Treasury officials, providing details of the fiscal changes they have pushed through and discussing what else might be needed.
"These guys down in Puerto Rico, they're determined to make this work," said Alan Schankel, a managing director at Janney Capital Markets, who recently visited the island.
But the coming weeks will be critical, and how Puerto Rico comes through depends, to some extent, on factors beyond its control. If its financial problems worsen, it may need some form of sovereign debt relief for which there is no direct precedent - and that would probably be subject to approval by a Congress now paralyzed and focused on a fiscal situation closer to home.
"A lot of people believe that the Territorial Clause of the United States Constitution gives Congress the power to impose control," said Robert Donahue, a managing director with Municipal Market Advisors, who has been discussing the situation with members of the President's Task Force on Puerto Rico, a group representing 16 Cabinet-level agencies and the White House.
One idea being considered is that Congress might establish a financial control board, perhaps like the one that helped guide the District of Columbia through a turbulent period from 1995 to 2001. One of that board's first steps was to appoint a financial official with power to override the mayor and City Council.
But with the federal government shut down, Donahue said, "there's really no path."
Despite its uncanny similarities to Detroit, Puerto Rico got into trouble in a sharply different way. Detroit owes the bulk of its debt to retired city workers, in the form of unfunded pensions and promises to provide health care. Puerto Rico has also made big pension promises, but the bulk of its debt is owed to investors that hold its bonds.
Until a few months ago, Puerto Rico was the belle of the bond markets. As a territory, it can sell bonds that pay tax-exempt interest in all 50 states, a rare and desirable trait. Puerto Rico's bonds also pay higher interest than many others because its credit rating is relatively low - but not low enough to scare off investors. Some of its bonds were insured against default; others have special legal structures that make them seem bulletproof. The territory's constitution explicitly states that general bond obligations have first call on all available resources.
Because Puerto Rico's bonds have these unusual advantages, investors snapped them up year after year, even as the territory's overall debt load started to snowball. In each of the last six years, Puerto Rico sold hundreds of millions of dollars of new bonds just to meet payments on its older, outstanding bonds - a red flag. It also sold $2.5 billion worth of bonds to raise cash for its troubled pension system - a risky practice - and it sold still more long-term bonds to cover its yearly budget deficits.
Mutual funds in particular were eager buyers; by adding Puerto Rican debt to an otherwise ho-hum portfolio, they could lift the overall yield without seeming to add much risk.
That cycle - a bountiful supply of debt feeding a seemingly insatiable demand - sputtered to a halt this summer, leaving Puerto Rico with more debt than it can easily pay. Its government must still borrow to finance its operations. Now it will cost much more to do so.
The Federal Reserve's signals earlier this year that it would ease its stimulus measures spooked the bond markets. Most states and cities have kept soldiering along, but the shocks left Puerto Rico effectively unable to borrow on the public markets.
In September, mutual funds and other institutions began to sell big blocks of its bonds, driving their prices down. That led to buying by hedge funds hoping to profit on a possible restructuring.
After the yields on Puerto Rico's outstanding bonds rose higher even than Greece's, Josi V. Pagan, the interim chief of the Puerto Rican Government Development Bank, announced that the territory would postpone most long-term borrowing for the rest of 2013. For now, he said, Puerto Rico would rely mainly on bank credit and private placements of short-term notes.
The three main ratings agencies have held Puerto Rico's general-obligation debt one notch above junk, despite the deterioration of the last few weeks. After the spate of selling in September, yields on its debt now correspond to those of speculative bonds.
"We found the actions that the government took credible," said Lisa Heller, a lead public-finance analyst at Moody's Investors Service. She said she wanted to see how well the government's reforms would take hold, given the difficulty of raising taxes and utility fees in a weak economy.
A one-notch downgrade would officially send Puerto Rico's general debt into junk territory, with troubling consequences. Puerto Rico, like Detroit and numerous other localities, is party to financial contracts known as interest-rate swaps, which require it to post cash collateral if its credit falls below investment grade. In addition, mutual funds and other institutions might have to sell their Puerto Rican holdings if they lose their investment-grade ratings. That could set off another damaging run.
Puerto Rican officials argue that the markets do not appreciate the tough fiscal changes that Garcia Padilla has made since taking office in January. He has frozen the biggest of the island's public pension funds, raised utility rates sharply, imposed new taxes and stepped up enforcement of existing taxes.
"I do not know a single state government, a single municipal government, that within six months of being elected undertook this amount of reforms," Bhatia told the analysts' group on Monday.
"I thought that in September I was going to come to New York and open a glass of Champagne with investors," he said, but instead, the analysts seemed to ignore all the government had done and demanded more.
Analysts at the meeting told Bhatia they had been following Puerto Rico's economy for many years and had heard previous administrations talk of great reforms, only to see deficit spending and borrowing continue.
"This time is different because we have approved the legislation that you have asked us to approve," Bhatia said, citing the pension overhaul and the sale of the island's biggest airport to private investors. The changes were "unparalleled to any reforms that I have seen in Puerto Rico over the last 30 years," he said, "and we are paying a very serious political price for it in Puerto Rico."
"I'll be blunt - we are frustrated," he said. "We are slowly, slowly seeing the initial results, the short-term results of our reforms. We need some breathing room. Puerto Rico is certainly doing its part."