Breakout

Why you need to care about Puerto Rico's debt

Breakout

Over the last week both Standard & Poor’s and Moody’s have downgraded Puerto Rico’s bonds to “junk.” The move exacerbates the Island Commonwealth’s already crippling debt burden and raises the very real possibility that a US bailout could be needed to save it from a full-scale economic meltdown.

Puerto Rico has more than $70 billion in municipal debt outstanding, a sum comparable in size to New York and California, though both of those states have much larger underlying economies. Unlike those states or even the city of Detroit, Puerto Rico is unable to file for bankruptcy and restructure under the umbrella of American law. Puerto Rico is officially an unincorporated territory, leaving it in something of a grey area for legal purposes.

According to David Kotok of Cumberland Advisors, Puerto Rico’s debt obligations are about eigh times the size of what Detroit is facing but without the same safety net for investors. In the attached clip Kotok explains that Puerto Rico is already getting what amounts to $2 billion a year in the form of a tax credit from a law that dates all the way back to 1921. That figure alone would “be enough to pay all the interest on their debt for a year” according to Kotok but it certainly hasn’t helped so far.

If the IRS decides to rescind the $2 billion credit Puerto Rico could plunge into chaos, leaving the 400 some mutual funds across the US that own the territory’s existing debt holding the bag. That’s unlikely to happen, but given the deterioration in the PR economy, even with the subsidy and the credit agency downgrades that continue to drive up the cost of capital for the island nation it’s hard to see how this story ends well.

Wealth and the population of Puerto Rico are migrating away from the country, services are collapsing and the murder rate exceeds that of Chicago. The threat for US investors is a loss of our entire investment and the risk to Puerto Rico citizenry is disintegration into economic anarchy.

“If we had a financial institution with $110 billion of liability we would call it systemic,” Kotok concludes, “This is an island of 3.5 million poor people. It could be systemic.”

As the US nears the fifth anniversary of its own near systemic collapse it’s unlikely tax payers are ready to rubber stamp another way. For those with money in funds exposed to Puerto Rican debt it might be time to reassess the risk.

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