In Spanish, there is an expression that “we are between the sword and the wall.” It is an apt description of the situation faced by Puerto Rico Governor Alejandro Padilla. Currently, the U.S. territory owes $73 billion to its creditors. To make matters worse, the Puerto Rican treasury is in the red to the tune of $370 million, and has already spent another $400 million borrowed in order to keep its government in operation. Puerto Rico also faces a $355 million revenue shortfall for the current fiscal year. The Government Development Bank, which issues bonds, is expected to be insolvent before the New Year.
This is bad news, not only for the average working people of Puerto Rico, but for investors holding Puerto Rico bonds as well. Nearly a third of Puerto Rico’s sovereign debt is held by U.S. mutual funds and hedge funds. According to financial analysts at Morningstar, more than one-fifth of U.S. bond mutual funds hold Puerto Rican securities, most of which are high-yield municipal bonds. Because of their tax-exempt status, Puerto Rico bonds have long been attractive to those saving for retirement. Sadly, many of those retirees have lost nearly everything, due to poor advice from self-serving brokers at UBS, Santander, and other institutions.
Puerto Rico’s impending financial downfall was the result of decades of well-meaning, but ultimately misguided, U.S. government policy intended to help the territory become self-sufficient. Part of this involved a provision of the Internal Revenue Code, which offered significant tax incentives to corporations willing to set up operations in Puerto Rico and provide jobs. Much of this was undone by ill-considered “free trade” agreements over the past thirty years. Then, with the passage of the North American and Central American Free Trade Agreements, those corporations who were the beneficiaries of those tax policies abandoned Puerto Rico for the low-wage maquiladoras and sweat shops overseas. Because those industries had largely replaced agriculture as Puerto Rico’s primary industry, the island has wound up having to import food to feed its people as well as oil in order to keep the energy infrastructure running.
Problems have been exacerbated by a kickback scandal involving Brazilian petroleum giant Petrobas (among other oil suppliers) and the Puerto Rico Electric Power Authority (PREPA), which was exposed earlier this year. To make things even worse (if that is possible), Puerto Rico is facing a wholesale exodus of its best and brightest to the U.S. mainland, who are seeking economic opportunities they can no longer find at home – further eroding the island’s tax base. Those remaining face an uphill battle in finding gainful employment; currently, Puerto Rico’s unemployment rate is around 12%.
Puerto Rico has a $300 million debt payment due on December 1, but as matters currently stand, a government shutdown appears to be the only way to avoid default. Only last summer, Governor Padilla acknowledged that Puerto Rico’s $73 billion public debt was “not payable.” Over the past year, Puerto Rican lawmakers and government agencies have been scrambling to find alternatives, including Chapter 9 bankruptcy (used by municipalities in the U.S., but not an option for Puerto Rico under current federal bankruptcy statutes), negotiations with creditors and attempts to crack down on tax collections. Right now, a government shutdown – which would hit the poor and middle class the hardest – appears to be the only viable alternative to default. Last week, Puerto Rico’s Secretary of Public Affairs, Jesus Ortiz, told the media, “We are aware that a possible government shutdown could affect the economy. We are doing all that is possible so that in December we won’t have to use a measure like that.”
Indeed. It will be the average working people of Puerto Rico who will pay the price, while Wall Street (as usual) walks away with their pockets full from fees and commissions. Those people hold most of Puerto Rico’s Public Finance debt though credit unions – and CNN Money has speculated that Padilla’s administration is “strategically choosing not to pay this debt” because those debt holders have fewer resources and are less likely to bring legal action.
Here in the U.S., investors are more concerned about how default will affect them. Puerto Rico bonds are already rated at “junk” status. This past August, Puerto Rico managed to pay out only $628,000 of the $58 million that was owed to bondholders. Because Puerto Rico is ineligible to seek Chapter 9 bankruptcy protection (unless Congress acts to change the law, which is highly unlikely), any restructuring of the island’s debt is going to be painful and messy, to say the least. If a restructuring is possible, it would be the largest in the history of the U.S. $3.7 trillion municipal bond market – and is likely to affect all investors who hold such bonds.
The financial institutions that knowingly pushed these high-risk bonds on to trusting, low-information investors are another matter. UBS, for example, has profited quite nicely from the Puerto Rico bond scandal. According to Levin Papantonio securities lawyer Peter Mougey, “UBS-Puerto Rico Funds, while setting up its investors with this kind of enormous risk, was positioning itself well to receive more advisory fees as a result of the amount of total assets under [its] management.” He adds, “[It is] a story of trust betrayed, knowingly and quite deliberately.”
UBS and Santander are two of the largest financial institutions on the planet, with combined assets amounting to trillions – and they are not the only financial services firms to have steered unqualified investors into these high-risk securities. If small investors are not able to collect from the Government of Puerto Rico, they will still have an excellent chance of recovering their losses from the financial institutions who misled them into these high-risk investments.