Puerto Rico: Paradise Lost

Puerto Rico labors under a debt load so burdensome it is little more than a patient on life support. The official public debt burden stands at $73.5 billion but there are an additional $38 billion of unfunded pension and public healthcare liabilities*. "El Nuevo Dia," the islands leading daily, recently advertised total indebtedness to be $167.43 billion. This includes adding the interest on the debt. Although this calculation is open to debate the debt problem is plenty bad. The debt addiction has left the island beleaguered and enervated with little political will to reform a society where half the population is on welfare and real GNP has contracted every year but one since 2006. No wonder Puerto Rico has for years been suffering steady emigration (think population declines) to the mainland, further contracting its potential tax base. Unemployment remains over 14 percent (actually down from 15 and 16 percent) and the poverty rate (41 percent) is twice that of America's poorest state, Mississippi. The per capita indebtedness is over 10 times the average of individual mainland states.

There is some palaver suggesting Puerto Rico's issues are not insurmountable. Government payrolls have been reduced by 35,000, and Governor Padilla has made numerous spending cuts with hope that the 2015 budget will be in balance or close to it for the first time in years. This is but a gesture and doesn't begin to address the necessary change in the ethos of the people of Puerto Rico. Fewer than one million of the 3.5 million people have regular jobs and one quarter of the overall workforce is employed by the government.

Mr. Justin Velez-Hagan, Executive Director of the National Puerto Rican Chamber of Commerce, estimates up to 40 percent of the island economy is underground or informal. Mr. Velez-Hagan comments, "Unfortunately, it has become culturally accepted to receive welfare. People want to work but it can be very difficult to weave through the labyrinth of bureaucracy to open any new small business... so this is what has evolved. In 2010 I investigated opening an assisted living facility for senior citizens. Between the new business licensing and registration process, the multiple bureaucratic layers among competing jurisdictions (state, municipality, city), which can take months or years to issue necessary construction permits , it would have taken me over 5 years for to open my business." Mr. Velez Hagan continues, "Entrepreneurship has dramatically slowed, and the incentive to open a business that depends on the local economy is weak. The government definition of reform is to enact laws that give tax breaks for big multinationals to locate here while providing few incentives for the local population."

What Mr. Velez-Hagan suggests is largely true. Until its recent expiration, Section 936 of the internal revenue code exempted U.S. corporations from paying federal income tax on profits generated by a qualified Puerto Rican subsidiary depriving the U.S. Treasury of billions in lost revenues. Multinational drug companies Johnson & Johnson, Pfizer, and Merck all have a Puerto Rican presence albeit smaller since the lapse of the 936 tax break. In the past couple of years the legislature has passed Tax Act 20, Tax Act 22, and Tax Act 273. These are all aimed at attracting wealthy individuals or export businesses to relocate to Puerto Rico. Act 22 exempts individuals 100 percent from payment of any taxes on any passive income, including dividends and any interest received. The other laws allow qualified corporations a 4 percent income tax rate while local corporations are trapped paying rates as high as 30 percent. So while Puerto Rico has had success attracting drug companies and certain high tech industries, the whole thing is held together with bubble gum. Though the economy remains around 45 percent manufacturing based, thousands of these high paying jobs have deserted the island as tax breaks have expired.
Currently many more Puerto Ricans reside on mainland USA than on the island. From April 2010 through July 2014 Puerto Rico's population declined by over 177 thousand people and by the end of 2015 is expected to reach 3.45 million, the lowest in a century. If this exodus continues to follow recent trends, the U.S. Census Bureau projects only 2.3 million souls residing on the island by 2050... a demographic nightmare. If this disaster scenario occurs, the tax base would be so eroded that it becomes a mathematical impossibility for the island debt to be repaid.
The last time Puerto Rico tapped the debt markets was in March 2014 at which time $3.5 billion was raised with an 8.72 percent coupon rate. It was about one month after much of the islands debt was relegated to junk status by the Standard & Poor's rating agency. Fast forward and island finances are in a far more parlous state today. And just last week both S&P and Moody's downgraded, even further into junk territory, $48 billion of Puerto Rico's General Obligation Bonds, warning of possible default in the next two years. Cash balances are precariously low, a $2.2 billion Highway Authority debt must be repaid, and now Puerto Rico is forced yet again to genuflect before capital markets and ask for $2.9 billion to be collateralized (repaid) from yet another in the ad nauseam litany of new taxes; this one just approved in January raises, by 68 percent, an existing levy on barrels of crude oil.

After this most recent debt downgrade, what rate will be necessary to entice the municipal bond funds to own this paper? Ten percent... 11 percent... who knows? For decades mutual funds and other financial institutions have been lured to finance politicians profligacy due to the islands so called triple exemption from local, state, and federal taxes.

The current official 2015 budget for the island is approximately $9.5 billion. Imagine having to refinance $40 or $50 billion of outstanding bonds and replacing interest rates of 2 and 3 percent with rates of 10 percent or more. Then suddenly over half the overall budget goes to paying debt service.

Unless and until Puerto Rico can adopt policies that encourage local growth unimpeded by mounds of stifling regulations the vicious cycle will continue: Lack of job opportunity results in emigration (or operating in the shadow economy), which reduces the tax base, making it harder and harder for the island to repay its obligations.

With a stagnating economy and scarce employment opportunity, politicians enacted a $1.36 billion potpourri of new taxes in 2013. And now, on the back of the new crude oil tax, Governor Padilla remarkably has the gumption to propose a 16 percent Value Added Tax (VAT) claiming it can raise an additional $1.6 billion. The local citizenry is basically forced to form an underground economy to survive what amounts to little more than a confiscatory regime.
Like the rat trapped in the corner, Puerto Rico is going to backdoor measures to abjure portions of their obligations. A recently passed "Recovery Act" attempted to allow some of the government agencies, (think, Puerto Rico Electric Power Authority (PREPA)), to be "eligible for court supervised restructuring." This is longhand for bankruptcy. Rightly or wrongly, Puerto Rico is not allowed, like mainland states and municipalities, to declare Chapter 9 bankruptcy which would allow a restructuring of debts. So a Federal judge quickly rejected the "Recovery Act" on grounds that it violated the constitution, reasoning state governments cannot modify municipal debts. Legal challenges will certainly follow, so this issue is far from settled.

PREPA is currently rated Caa3, which translates to a high likelihood to default on over $9 billion coming due. The Puerto Rico Aqueduct and Sewer Authority and the Puerto Rico Highway and Transportation Authority also sport debt ratings deep in "junk" territory, implying significant risk default. So the situation is dire, and there is no place else to kick the can.

As often happens in our no responsibility world, Congress is stepping into the void and over the next few days will debate the Puerto Rico Chapter 9 Uniformity Act of 2014, which as the name implies would vouchsafe to Puerto Rico the right, (privilege) to declare bankruptcy.

Assuming this bill becomes law, in a matter of nanoseconds Puerto Rico will avail itself and be under a court supervised Chapter 9 proceeding. If we use the Detroit bankruptcy debacle as a guide, here is what may happen to current bondholders. Interestingly, tax supported General Obligation (GO) bonds took big hits, some issues getting less than 50 cents on the dollar. Investors lost billions. Also, when a majority of investors voted for settlement the minority suffered a "cram down" and was forced to accept. Detroit's dedicated revenue bonds, like the$2.9 billion issue proposed to be backed by the new crude oil tax continue to be paid in full. The troubling thing to me is that, allowing a Chapter 9 for Puerto Rico, changes the rules in the middle of the game. Investors placed their bets with one set of laws and now they might (unfairly in my opinion) be subject to new rules. In a society with true rule of law, bond covenants should remain sacrosanct.

At the end of the day, no amount of debt forgiveness solves the structural problems facing Puerto Rico. Until the state bureaucracy is dismantled Puerto Ricans will continue to flee to the mainland. Meanwhile, stay away from any investment in Puerto Rican bonds. They are hazardous to the pocketbook.

* From the Puerto Rico Comprehensive Annual Financial Report.