Can Puerto Rico Default on Its Debt?

The Puerto Rican debt conundrum reared its head again Monday, just weeks after Hurricane Maria wiped out the island, leaving most residents without power, water and other necessities. As the local government grapples with the huge financial bill that lies ahead, investors are anxiously awaiting details on how the Commonwealth plans to deal with its already escalating debt obligations. 

The problem of Puerto Rico's $73 billion debt obligation is nothing new. The issue was exacerbated when President Donald Trump spoke before his visit to the capital, San Juan. "You know, they owe a lot of money to your friends on Wall Street and we’re going to have to wipe that out," Trump said in an interview on Fox News.

"You can say goodbye to that. I don’t know if it’s Goldman Sachs, but whoever it is, you can wave goodbye to that."

After the president's comments, debt on a 2035 maturity bond fell to a record low of 32 cents on the dollar, and yields rose towards 20 percent, up more than 6 percent before the September 19 hurricane. (See also: The Origins of the Puerto Rican Debt Crisis.)

How Puerto Rico Amassed Its Debt

Since the turn of the century, the Puerto Rican government sought to raise money as it embarked on a spending spree to increase tourism and infrastructure. However, in 2007 Puerto Rico fell into a deep recession and has yet to recover. Year-on-year growth has contracted in all but one year (2012) since 2007, and as unemployment soared, locals fled the island, draining the government of tax revenue. 

Puerto Rico's spending continued, however, and to fund it the government issued high yield bonds bonds. In addition, the bonds were triple-tax exempt, meaning they are exempt from federal, state, and local taxes. Given the combination of tax exemptions and high yields, the government amassed a debt burden that has come home to roost. (See also: How Does the Puerto Rican Debt Crisis Affect the US?)

While Puerto Rico's debt-to-GDP ratio of 67 percent is relatively low by global standards, the inefficiency of the economy puts it at risk of ballooning fast as the economy continues to contract at a rapid rate. 

Who Owns The Debt?

Despite Trump's comments that Puerto Rico owes a lot of money to Wall Street, Puerto Rico's obligations are far from just Wall Street banks and hedge funds. In fact, a substantial portion of the government debt is held by "mom and pop," small investors. According to Cate Long, founder of Puerto Rico Clearinghouse less than 25 percent of the debt is owned by hedge funds, and 75 percent is held by at least 500,000 retail investors. 

Data compiled by Bloomberg shows the debt situation in Puerto Rico is not just government related, other state departments have issued these kinds of debt:

  • General: debt guaranteed by the commonwealth and paid for out of its general fund
  • COFINA: debt issued by the commonwealth's Sales Tax Financing Corporation
  • PREPA: bonds issued by the Power Authority which is funded from electricity sales revenue
  • Pension-related: debt owned by the commonwealth to both current and future retirees
  • Other: this debt of the University of Puerto Rico, the Sewer Authority, and the Transportation Authority

Can It Simply Default?

After Trump's statement that the debt will have to be "wiped out" investors are wondering exactly what this means, and, more to the point, can it be done.

As Puerto Rico's crisis deepened in 2016, many debt holders began to file claims against the government because it was not protected through bankruptcy. As filings mounted, the U.S. government enacted a special bill, PROMESA (The Puerto Rico Oversight, Management, and Economic Stability Act) that put finances of the territory under federal oversight to stop mounting court filings. 

Now at the hands of the U.S. government, President Trump is looking to reduce or completely wipe out the debt. However, debt reductions are governed by federal laws, meaning the bondsholders have the right to protect their bonds. So by "wiping out" the debt, Trump is saying he plans to negotiate with bond holders to come to a fair and reasonable agreement on the term of a debt reduction. 

Take Away

Puerto Rico is not the first, and won't be the last debt crisis. However, what's different about this one is both the exit plan and the debt obligations. While President Trump may want to "wipe it out," it's not that easy. Debt holders have just as much of a right as asset owner, and any haircut, or agreement will come with a lengthy negotiation period. 

Sadly, for the people of Puerto Rico, the financial risks fall at their feet and to make matters worse the debt issue is beginning to override the humanitarian concerns. More than two weeks after the devastating hurricane only 7 percent of people have electricity and less than half have access to drinking water. 

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