Puerto Rico is in massive debt

Puerto Rico has the population of Oklahoma and an economy smaller than Kansas. It also has more debt — $70 billion — than any U.S. state government except California and New York. This fact and the reasons behind it help explain why the territory has tumbled over a fiscal cliff, and why the resulting dismay extends to investors far beyond the Caribbean island. It’s atale of financial mismanagement, Wall Street complicity and good intentions gone awry.

The Situation

After stating in 2015 that it was unable to pay its borrowings, Puerto Rico’s government began talks with creditors and turned to Washington for help. Two agencies defaulted before the commonwealth proposed avoluntary plan in February to slash the debt load almost in half by repaying 39 to 72 cents on the dollar.  Puerto Rico then upended months of negotiations by passing a debt-moratorium law that allows Governor Alejandro Garcia Padilla to suspend through January 2017 payments to investors on a wide swath of bonds. The island faces a $2 billion bill for principal and interest payments on July 1. Under federal law, states can authorize bankruptcy filings by their municipalities, including public utilities, but Puerto Rico can’t. The U.S. Congress isworking on a bill that could allow Puerto Rico to restructure its debt and implement a federal oversight board that would weigh in on the commonwealth’s budgets. In March, the U.S. Supreme Courtheard arguments on whether Puerto Rico can reinstate a local law that would give its utilities additional leverage in talks with lenders; a decision is expected by June. The island’s plight affects most people with a mutual fund invested in the municipal bond market. Unlike the bonds of most states and municipalities, Puerto Rico’s are exempt from local, state and federal taxes everywhere in the U.S. As a result, they are held by about half of open-end muni funds. The competitive advantage made it easy for Puerto Rico to double its debt in 10 years by selling bonds to plug annual budget deficits and pay for operating expenses — the same combination that brought New York City to the brink of bankruptcy in the 1970s.

The Background

Wall Street smoothed the island’s path to fiscal debacle, reaping more than $900 million in fees to manage Puerto Rico’s $126.6 billion of bond sales since 2000. After the U.S. territory adopted a sales tax in 2006, investment banks worked with officials in San Juan to create new bonds backed by a portion of the proceeds. These helped the government, which employs more than a quarter of the workforce, put off cuts. Puerto Rico, ceded to the U.S. in 1898 after a war with Spain, has a special tax status that dates to 1917 and the passage by the U.S. Congress of the Jones-Shafroth Act. It has relied on tax breaks to drive economic development, attracting pharmaceutical, textile and electronics companies. The U.S. phased out the incentives from the mid-1990s to 2006, contributing to the loss of 80,000 jobs. Since 2006, the island’s economy has contracted every year except one and its poverty rate is now almost double that of Mississippi, the poorest state. The population, now about 3.5 million, is shrinking and forecast to reach a 100-year low by 2050.