The Bonds That Broke Puerto Rico

http://www.nytimes.com/2015/07/01/business/dealbook/the-bonds-that-broke-puerto-rico.html

Version 0 of 1.

When Puerto Rico’s governor told lawmakers and citizens on Monday that the commonwealth could not pay its $72 billion in debt, many wondered how a small, seemingly low-key American island in the Caribbean could have amassed a debt big enough to crush it.

The answer lies in a confluence of factors, including American investors’ desire to avoid taxes; the mutual fund industry’s practice of competing on the basis of yield; complacency about the practice of long-term borrowing to plug holes in budgets; and laws that supposedly give bond buyers ironclad guarantees.

That brew of incentives has produced truly staggering numbers. On a per-capita basis, Puerto Rico has more than 15 times the median bond debt of the 50 states, according to Moody’s Investors Service. The governor, Alejandro García Padilla, said on Monday that at the rate the debt situation is developing, every man, woman and child on the island would owe creditors $40,000 by 2025. High unemployment means fewer resources to pay off what is owed.

“We cannot allow the heavy weight of the debt to bring us to our knees,” the governor said in a live televised address, proposing a debt restructuring.

For years, investors were lining up to lend Puerto Rico money, so it was easier to borrow than to fix any number of financial or structural shortcomings. Many of the lenders were middle-class Americans who knew little or nothing about Puerto Rico, but simply opted for one of the many tax-exempt municipal bond funds that have become popular.

Such funds have appeared to offer both low risk and a tax shelter. They have long catered to residents of higher-tax jurisdictions, like New York City, San Francisco and Philadelphia, where people pay three layers of income tax, to federal, state and local authorities. In other places, like Maryland and Indiana, the local income taxes are paid to counties, not cities, which makes them harder to escape.

For tax-weary residents, bonds issued by United States territories and commonwealths offer a unique way to avoid these taxes lawfully. Investors who buy these bonds can exclude the interest paid to them from their taxes, no matter what state they live in.

This feature has made Puerto Rico’s bonds extremely attractive and relatively easy to market. Mutual fund companies snapped them up, sprinkling Puerto Rican debt into their tax-exempt bond funds, which bear the names of the various states — New York, Pennsylvania, Virginia and others — where the tax-averse investors lived. It is estimated that 75 percent of the mutual funds tracked by Morningstar now hold at least some Puerto Rico debt.

And sometimes it is more than just a sprinkling, as mutual funds look to increase their returns. The Oppenheimer Rochester Maryland Municipal Fund, for example, held more Puerto Rico bonds than Maryland bonds as of May 31: 49.7 percent compared with 45.3 percent. Maryland’s credit rating is AAA, so its low-risk bonds offer just a sliver of a reward. Puerto Rico bonds are riskier, so they yield more, and adding them to the mix increases the return.

The Oppenheimer Virginia fund is 40.2 percent Puerto Rico bonds, and its North Carolina bond fund has 35.3 percent. The holdings are disclosed on its website. A spokesman said Oppenheimer believed Puerto Rico had enough money to repay all of its debts.

As if that wasn’t enough, Puerto Rico made borrowing even more attractive. Its constitution contains an unusual clause that requires general-obligation bonds to be paid ahead of virtually any other government expense. And in case more reassurance was needed, the government created backstops, lockboxes and guarantee mechanisms for general-obligation and other types of debt, identifying specific revenue streams and promising them to certain groups of bondholders.

This practice is not at all unusual, especially in cases of deep distress, because local governments still have to borrow, even when they are broke.

Puerto Rico has been making pacts like that for years, locking up more and more of its resources to secure more and more bonds. That made them easier to sell, which in turn reduced borrowing costs at the outset. But over the long term, it left less and less money to provide essential government services.

“This is the main problem with the muni market,” said Matt Fabian, a partner at Municipal Market Analytics. “We don’t worry, generally, about how bond proceeds are spent. We worry about how bonds are repaid.”

In 2006, for example, the Puerto Rico government created an independent debt-issuing authority called Cofina, which had first claim to a fixed portion of all sales taxes on the island, to offer as collateral for bonds. That meant less sales taxes for public services, and, after issuing nearly $15 billion of bonds, Cofina had exhausted its capacity — and Puerto Rico still had to borrow.

The 2008 financial crisis hit the island hard, and even though the government sharply cut spending, laying off tens of thousands of public workers and privatizing marquee properties like the Luis Muñoz Marín International Airport in San Juan, tax revenue fell even faster. The government filled budget holes by issuing more bonds.

“You can do that for a short time, but you can’t do that forever,” Mr. García Padilla said in an interview last week.

As the borrowing expanded, the island searched for more revenue streams to pledge as security for the bonds. Complicated deals were struck in which the Government Development Bank — the government’s fiscal agent — used one arm of the government to borrow on behalf of another, making it hard to be sure whose obligation the bonds really were. The tourist authority might borrow money, then send some of the cash to the electric authority, which used it to pay its bonds, while the tourist hotel projects languished. Years of maneuvers like that left less money available for the normal activities of government — like policing, staffing the public schools and providing clean water. But bondholders may not have sensed the crisis brewing because they still had pledges of collateral, lockbox arrangements and other recourse measures available to make sure they were paid.

Government spending and debt service became a Rubik’s cube of interrelated, crisscrossing payments. In 2012, Moody’s decided to solve the puzzle and found there were about $10 billion more bonds outstanding than it had counted before. It also reported that the island had issued $1.1 billion of bonds the previous year, of which $850 million bought no lasting public works but just serviced existing debt and plugged budget holes.

In May, Puerto Rico made the remarkable announcement that its main pension system was down to just seven-tenths of a penny for every dollar the retirees are due. A properly funded pension system has 100 cents on the dollar. It is not clear how the pension system is paying retirees, but when its remaining seven-tenths of a penny is spent, it will become a pay-as-you-go system, with hundreds of millions of dollars of new claims on the central government.

Mr. García Padilla did not make his debt restructuring plans explicit in his televised speech, but he did say he was “guaranteeing our citizens essential services and our pensioners a just income.”

That could mean that at least some of the bond security measures will be tested. Puerto Rico and its advisers set up the lockbox system, where the government must deposit its general-obligation bond payments several months in advance. Those payments are now costing the island $92 million a month.

Lawmakers in Puerto Rico are working on legislation that would authorize the suspension of those payments. But if the payments cease, general-obligation bondholders will sue. And if they sue, other types of creditors may sue to protect their interests. And because Puerto Rico is a commonwealth, it has no way to seek shelter in bankruptcy court, where the judge could stay all creditor lawsuits. Without the automatic stay of bankruptcy, a “negotiated moratorium” that Mr. García Padilla said he wants could swiftly devolve into a destructive and Darwinian creditors’ free-for-all.