Puerto Rico’s Looming Debt Crisis

BY ALEXANDRA LEVENSON — While the financial industry seems to be bouncing back from the effects of the 2008 financial crisis and Detroit’s record-breaking municipal bankruptcy, another potentially even greater financial crisis is looming – in Puerto Rico. Home to 3.7 million people, Puerto Rico owes a staggering $70 billion in public debt, behind only New York and California, despite a smaller and poorer population.[1] As a point of comparison, in America’s fifty states, the average ratio of state debt to personal income is 3.4%.[2] Rating agency Moody’s puts Puerto Rico’s tax supported debt at an astounding 89%.[3]

America gained control over Puerto Rico in the Spanish-American war of 1898. Puerto Ricans are American citizens and receive American government pensions, yet pay no federal income tax on their local income.[4] Puerto Rico has long been of enormous importance to America’s almost $4 trillion municipal debt market because of its high yields and exemptions from federal and local taxes.[5] In fact, nearly 70% of U.S. municipal bonds rated by Morningstar have some kind of exposure to Puerto Rico due to the bonds’ “triple exemption” status; meaning regardless of what state you live in, if you own a Puerto Rico bond, you don’t pay federal, state, or local taxes on the interest.[6] Puerto Rican bonds also pay a higher interest rate because of its relatively low credit rating. Because of these particular appeals to investors, Puerto Rico has continued to borrow despite its unstable financial condition.

Moreover, Puerto Rico’s economy has serious structural problems – participation in the labor force is only 41%, some 20-percentage points below that of America’s.[7] Moody’s analytics believes Puerto Rico’s public sector accounts for 20% of employment, compared with 3.7% for the average state.[8] Unfortunately, the result is stunted growth and investment. To make matters worse, the more Puerto Rican have emigrated, causing the remaining population to shrink.

Territories like Puerto Rico have no ability to file for bankruptcy.[9]  Yet, Puerto Rican officials contend that the territory is not bankrupt and is working responsibly to solve its financial issues. In each of the last six years, Puerto Rico sold hundreds of millions of dollars of new bonds in order to meet payments on its older bonds – which should be a red flag to investors. It also riskily sold $2.5 billion worth of bonds to raise cash for its troubled pension system[10], which is only 7% funded.[11] However, this cycle of abundant debt supply feeding investors’ high demand slowed to halt this past summer and has left Puerto Rico with more debt than it can pay, and yet its government must still borrow to finance its operations. An inability to borrow could lead Moody’s to downgrade Puerto Rico’s debt, putting it at the junk bond status, and the White House has said it will not provide a bailout.[12] Moody’s estimates that if Puerto Rico does get downgraded to junk status, it could face $1 billion in additional short term costs on loans that are contingent on Puerto Rico securing a higher rating.[13]

Just last week, Puerto Rico’s Senate approved measures to help the territory’s borrowing capacity by creating a corporation responsible for issuing bonds to help refinance debt held by the island’s municipalities using a portion of revenues generated through an existing sales tax.[14] Another measure approved last week would create a special fund for these revenues to be overseen by the Government Development Bank.[15] While these new developments may be a step in the right direction, only time will tell whether they will be effective in preventing a Puerto Rican debt crisis or whether the White House will need to reconsider a bailout.