Will Puerto Rican Bonds Trigger a Mainland Bailout?

Financial bailouts have become a fact of American life. Yet the biggest bailout of all may be in Puerto Rico, home of photogenic beaches, lush forests, chic nightclubs, and less happily, at least $70 billion in public debt, more than double the sum from 2004. The U.S. mainland is yoked to this debt. Well over 50 domestic municipal bond funds have at least 10 percent of their assets invested in Puerto Rico. Worse, the island economy is in a prolonged recession. Unemployment has been running at around 15 percent. A third of residents are on food stamps. And migration to our shores is accelerating. Puerto Ricans for nearly a century have been U.S. citizens. But full-fledged statehood – increasingly supported by island residents and both major political parties – could enable a bailout more than anything else.

The Commonwealth of Puerto Rico, with a land area of about 3,500 square miles and a population of 3.67 million, is a case of political schizophrenia. Our government took possession of the main island and nearby small islands from Spain in 1898 following our victory over that country in the Spanish-American War; Puerto Rico, along with the Philippines and Guam, was part of the booty. In 1917, as part of the Jones-Shafroth Act, the U.S. granted automatic citizenship to Puerto Rican residents. After World War II, in 1950, Congress enacted legislation authorizing Puerto Rico to hold a constitutional convention. Two years later, in 1952, the island government adopted a constitution and proclaimed its territory a commonwealth. Congress and President Truman quickly approved the action.

In the six decades since, Puerto Rico’s political status remains an odd hybrid of autonomy and colonialism. The Caribbean island has greater authority than were it to have remained a mere territory. Yet its representative in Congress, formally known as Resident Commissioner, cannot vote on any bill. Residents may not vote in a presidential election unless they move to a state. And its periodic voter plebiscites (i.e., referenda) to determine its future form of government carry no force of law. These plebiscites have offered three legal alternatives: commonwealth, statehood and independent republic. Beyond the 1952 plebiscite establishing the commonwealth, the Puerto Rican government held plebiscites in 1967, 1993, 1998 and 2012. Each time, the pro-statehood and pro-commonwealth position generated sizable support. Statehood has become increasingly popular, consistently attracting support of around 40 to 50 percent of all votes. The pro-independence position, by contrast, never has gotten more than a tiny share of the vote.

The U.S. government long has promoted economic development on the island. During the pre-commonwealth era, the mainstays of the Puerto Rican economy were coffee, tobacco and spice exports raised on small plantations. Starting in the Forties, island farmers switched to sugar, a move largely dictated by market demand from the mainland and aggressive lobbying by growers and refiners to set sugar prices well above market levels and establish export quotas. It was in the Forties as well that Puerto Rico began its transition to a modern industry-based economy, aided by the creation in 1947 by an initiative known as Operation Bootstrap. Through an island government-owned corporation created several years earlier, Puerto Rico Industrial Development Company, the U.S. offered a combination of subsidies, tax exemptions and import duty waivers to entice U.S. companies to build plants on the island. The program proved success is attracting manufacturing, especially shoe factories and textile mills. Development received a further boost in 1976 when Congress, at the urging of the Puerto Rican government, enacted Section 936 of the IRS code, permitting U.S.-based corporations to repatriate annual earnings without paying federal income taxes. Through the 1980s, island authorities estimated, the law was directly responsible for the creation of 100,000 jobs and indirectly responsible for the creation of another 200,000. Section 936 was especially a catalyst for attracting pharmaceutical plants. U.S. lawmakers, however, came to see the law as a tax dodge, and in 1996, repealed it, albeit by phasing out benefits over 10 years.

Development has proven a mixed blessing. It has alleviated poverty, built a sizable middle class, and promoted tourism. And it’s been a good deal for Puerto Ricans, many of whom pay no personal federal or local taxes on island-derived income. Yet they also have produced a widespread attitude, especially among public officials, that business revenues can fund public-sector expansion in perpetuity. The Puerto Rican government has laid out enormous expenditures for infrastructure, service delivery and anti-poverty transfer payments based on heavy tax-free borrowing. Unfortunately, broad economic and social indicators have raised the risk of default these past several years. Unemployment has been hovering at around 15 percent. More than a fourth of all gainful employment is in government (the U.S. average is 16 percent). Fully 1.3 million residents, roughly a third, receive food stamps, while Social Security disability benefit usage is about twice the rate as on the mainland. And crime, always an impediment to investment, is rampant. According to FBI Uniform Crime Reports, the island in 2012 had 26.7 homicides for every 100,000 residents; the U.S. mainland figure was 4.7 per 100,000.

Recession has been a reality in Puerto Rico since 2006. The relocation of clothing manufacturers to more favorable ports, the expiration of key drug patents, and a severe residential mortgage bust each have contributed to the downturn. Indeed, the manufacturing decline began a decade earlier. The number of factory jobs on the island has dropped from about 160,000 to 75,000 since 1996. In response, Puerto Ricans are heading for the exit door. In 2012 more than 60,000 people departed the island for mainland destinations, especially in the Miami-Dade County and Orlando areas. This is outmigration on a level not seen since the 1950s. “It’s a pretty broad cross-section of the population leaving, which includes everyone able to pay for a ticket,” notes Jorge Duany, a demographer at Florida International University. Indeed, at present, an estimated 58 percent of all Puerto Ricans now live on the U.S. mainland.

These circumstances have weakened the island’s ability to borrow on favorable terms, not to mention pay off existing debts. As of this October, Puerto Rican general obligation bonds, though free from federal, state and local taxation, lost close to a fifth of their value in 2013. Currently, they carry the lowest possible investment-grade rating by Moody’s (Baa3), Standard & Poor’s (BBB-minus) and Fitch (BBB-minus). If they were any lower, they would be classified as junk bonds. Carlos Colon de Armas, an economist and former official of the island’s Government Development Bank, puts it this way: “We are now in a situation where the bonds are trading like junk. I think the ratings agencies have been careful not to lower the G.O.s (general obligation bonds) further, to avoid creating havoc in the muni-bond market.” Further downgrades could be disastrous. Interest rates have shot up to compensate for the risk of default, making repayment even more difficult and raising insurance costs in the credit default swaps market.

U.S. investors are overwhelmingly the holders of these bonds. And that puts our economy at risk. According to the market research firm, Morningstar, three out of four of the more than 400 U.S. municipal bond mutual funds have at least some Puerto Rican bonds in their portfolios. An article appearing this September in Forbes magazine titled “Do You Own the Next Detroit?” highlighted the dilemma. Citing Morningstar data, the article indicated that 55 municipal bond funds have 10 percent or more of their assets invested in Puerto Rico. The most exposed fund, Franklin Double Tax-Free Income, has 63.4 percent of its $633 million in assets there. In a distant second place is Rochester Municipals, with a 22.4 percent exposure on its more than $7.5 billion portfolio. At the time of the article, Rochester Muni was down 10.9 percent, more than double the loss for the Barclays Capital Aggregate Bond Index.

All told, Puerto Rico has at least $70 billion in outstanding mostly high-yield, high-risk public-sector bonds, a sum representing nearly 2 percent of America’s $3.7 trillion municipal bond market and nearly $20,000 for every man, woman and child on the island. Let’s compare this with the debt situation in two problem states. California, whose population is more than 10 times that of the island, has a cumulative $96.4 billion worth of stated-funded debt. And New York, with more than four times Puerto Rico’s population, has $63.3 billion in outstanding state debt. Proportionately, Puerto Rico has a Third World-style debt problem. It’s a good thing its population is less than 4 million.

The situation has its parallels. A decade ago, writing in the Spring/Summer 2003 issue of the Cato Journal on the sovereign debt crises in Argentina and Brazil, Columbia University professor Charles Calomiris observed that the exploding debt in these two nations had been the result of overconfidence among their political leaders. He wrote:

Economic “emergence” – the combination of industry privatization, trade liberalization, price stabilization, and financial deregulation – would work much better if sovereigns did not see market optimism about their private-sector prospects as an opportunity to ramp up their expenditures. Imagine how much better off the people of Brazil and Argentina would be today if their governments had not been able to borrow in the international bond market during the 1990s.

What were government officials thinking? Wouldn’t even a self-serving politician or bureaucrat do better in the long run by waiting until after growth had succeeded before increasing government expenditures? The problem is twofold. First, politicians do not have long time horizons. That failure ultimately must be seen as a political failure of democracy in EMs. Second, local bureaucratic interests can be impervious to change even when politicians try to cut spending. That was particularly true in Argentina and Brazil, where spending was often decided at the local level but paid for at the national level.

These words could apply to Puerto Rico today. Political leaders on the island, supremely confident of their ability to borrow and spend without ill consequences, have gone on a borrowing and spending binge, with an ample assist from Wall Street brokerages. But there is also a huge difference: Puerto Rico is not a foreign country. In the case of deadbeat debtor nations – particularly Argentina, which in 2001 defaulted on about $80 billion in foreign bonds and to this day has refused to pay any of it back despite several court orders to do so – our primary challenge is to collect what is owed to us. In the case of Puerto Rico, our primary challenge is to wean its officials away from acquired bad habits.

Like all 50 states, the Puerto Rican government is barred from filing for Chapter 9 bankruptcy. Yet the island has an additional hurdle. Where individual public agencies (e.g., a utility or a housing authority) in a given state can file, those in Puerto Rico cannot. Thus, the island government has two options: 1) pay its debts; or 2) default. The first alternative is by far the most desirable. Yet it won’t be easy. High public services costs, unemployment and outmigration have combined to bring the island to its breaking point. And though the pace has slowed, the debt continues to pile up. Puerto Rico recently issued more than $3 billion in bonds to cover short-run costs of its already severely underfunded (by $37 billion) public pension system. And this summer the island’s Electric Power Authority sold $673 million worth of improvement bonds – $73 million more than originally planned; its highway authority issued another $400 million. Island authorities have tried raising taxes, adopting a 7 percent sales tax. That has closed the budget gap for the time being. But over the long run, it is more than likely to discourage business formation and expansion.

The other option is default. That would be easier than paying off debt. But the consequences could be devastating. Though the Puerto Rican constitution guarantees bondholders timely payment, that guarantee would be meaningless without financial backing. A default would trigger a downgrading of potentially all bonds to junk status, cutting the island off from further borrowing at anything but exorbitant costs. Paying off current debts would be next to impossible, making a large-scale federal bailout a very real possibility. Deepak Lamba-Nieves, research director of the San Juan, P.R.-based Center for a New Economy, admits the crisis has been brought on by aggressive borrowing. He explains: “You cannot pay daily expenses with your credit card, and that’s what Puerto Rico has been doing for years.”

A rolling bailout has been the reality for some time. In fact, the federal government now covers $6.7 billion, or close to a fourth, of Puerto Rico’s current fiscal year (which began on July 1) budget of $29 billion. By contrast, for the last three decades, the contribution of federal grants to state and local governments has been about 15 percent. The Obama administration has not indicated it would support a special financial aid package. Yet statehood, if it were to come about, would open the funding spigots. And support for statehood, if gradually, is winning the day.

It’s hard to see how statehood would benefit the American people as a whole. Puerto Rico is an island. Its principal language is Spanish. Its sense of history, more than any mainland state, is defined by anti-American grievance. And its economy is far more welfare-dependant than ours. But statehood would benefit Puerto Rico. For by becoming a state, Puerto Rico automatically would be eligible for a wide range of federal aid. Pedro Pierluisi, Puerto Rico’s current representative in Congress, knows this as well as anyone. Writing this November in the Washington Times, he observed:

Puerto Rico loses out on billions of dollars annually because it is treated unequally under a range of federal programs, including tax credits available to millions of households in the states that do not pay federal income taxes. Contrary to common belief, Puerto Rico employers and workers pay federal payroll taxes, and the Internal Revenue Service collected more than $3.5 billion in individual and corporate taxes in the territory in 2012, nearly as much as the agency collected in several states. To compensate for the shortfall in federal dollars, the Puerto Rico government must borrow heavily to provide adequate public services. This disparate treatment is the principal reason that Puerto Rico has faced severe economic problems for at least four decades, carries more than $70 billion in debt, and has bonds trading at near-junk levels.

Pierluisi, who also is president of the pro-statehood New Progressive Party, effectively is arguing here that Puerto Rico shouldn’t be held responsible for its own economic mismanagement. Apparently, “unequal” treatment (by the United States) explains the problem. That the federal government now pays for about a fourth of the island budget apparently is insignificant. Understand this much: Statehood is not an alternative to a federal bailout. It is a federal bailout.

For years, Capitol Hill has been moving in this direction. In 2000, Congress approved and President Clinton signed legislation to sponsor Puerto Rican political status choice; funds expired before a plan could be developed. In 2007 and 2009, lawmakers introduced proposals to fund resident self-determination. The legislation, the Puerto Rico Democracy Act, would have provided federal support for a nonbinding plebiscite. This would have marked the first time the federal government subsidized such a vote. The House of Representatives passed the 2009 version in April of the following year by a convincing 223-169 margin; the Senate, for its part, did not take action. For good measure, though Republicans look far less favorably toward statehood than do Democrats, they, too, have their supporters, especially Rep. Ileana Ros-Lehtinen, R-Fla., and anti-tax activist Grover Norquist, both of whom showed up at a pro-statehood rally in Washington last month. Both parties, in fact, include support for statehood in their platform. And President Obama has said that he supports statehood if a clear majority of people on the island want it.

The administration and its allies in Congress are putting words into action. The White House recently named an advisory team to assist Puerto Rican officials handle the growing crisis. And as part of the Fiscal 2014 budget (now in its final stages of negotiations), the full House Appropriations Committee in July approved an Obama administration request of $2.5 million for an eventual plebiscite, a move that would pass the Puerto Rico Democracy Act all but in name. The money would go to an island government agency, the Puerto Rico State Elections Commission. Though ostensibly promoting equal representation from among Puerto Rico’s parties, the funds would serve as a stalking-horse for statehood. The strongly pro-statehood Pierluisi implies as much. “The White House recognizes that the majority of the American citizens of Puerto Rico revoked their consent to maintain the current territorial status on November 6 (2012),” he remarked upon the unveiling of the original Obama White House proposal. Rep. Jose Serrano, D-N.Y., one of several stateside Puerto Ricans in Congress, supports the plan. Rep. Edward Markey, D-Mass., ranking minority member on the House Committee on Natural Resources, which covers Puerto Rican issues, also is enthusiastic. House Minority Whip Steny Hoyer, D-Md., is especially explicit in his support for statehood. “I am pleased that President Obama has included in his budget a request to conduct the first federally-sponsored status vote in Puerto Rico’s history, responding to the November plebiscite held in Puerto Rico where voters rejected the current territory status and expressed a desire for statehood.”

The ultimate arbiters, the people of Puerto Rico, are tilting, though not definitively, in favor of statehood. In November 2012, the Puerto Rican government placed the issue on the ballot in the form of a two-part plebiscite. The first question asked voters whether the island should remain a U.S. commonwealth. Fully 54 percent voted “no.” The second question asked whether they preferred commonwealth, statehood or independence. Of about 1.3 million votes cast, nearly 800,000, or slightly over 60 percent, preferred statehood; 437,000 and 72,560 voters, respectively, chose the commonwealth and independence option. Significantly, close to 500,000 voters left the question blank. The island will remain in political limbo in the near future. Yet prospect for statehood is stronger now than at any time in the past. And in the meantime, U.S. taxpayers will continue to subsidize island budgets.

“It is manifest destiny for a nation to own the islands which border its shores” – so declared President Teddy Roosevelt, hero of the Battle of San Juan Hill of 1898. In a much different sense, the island of Puerto Rico is our manifest destiny today. The costs of this uneasy paternalistic relationship have become increasingly clear. In theory, independence would be the best alternative. Far more than territorial commonwealth or statehood status, the reconstitution of Puerto Rico as a republic would relieve us of having to keep the island on life support. And it would give this distinct people their own nation-state.

The problem is that very few Puerto Ricans want it. In a real sense, the people on the island haven’t gotten over the pro-independence terror inflicted on our nation’s capital some 60 years ago. To refresh one’s memory, in 1950, two nationalist gunmen very nearly assassinated President Harry Truman outside Blair House, where he was temporarily living, across the street from the White House. Though the president (observing the action from inside) was unhurt, a White House police officer was murdered, though not before killing one of the assailants. Four years later, in 1954, four gunmen seeking independence for Puerto Rico opened fire on the U.S. House of Representatives from a balcony in the Capitol Building, wounding, though not fatally, five congressmen. In 1978, President Jimmy Carter commuted the sentence of one of the assailants. The following year, he pardoned the remaining three attackers. Only days earlier, President Carter had issued a pardon on behalf of the surviving member of the two-man team that had tried to take President Truman’s life at Blair House.

So what course should the U.S. take, given the range of unpalatable choices? Territorial status has created an unhealthy dependency. Statehood would deepen the fiscal sinkhole. Independence has almost no support. The best thing for our officials to do is to recognize that Puerto Rico’s fate lies in its own hands – and convey this view to its officials. The situation also calls for maintenance of the island’s commonwealth status, at least in the foreseeable future.

Repaying debt won’t be easy, but it is achievable. And some recent trends are encouraging. Fitch affirmed its AA-minus and A-plus ratings on $15.6 billion worth of Puerto Rican sales tax bonds. Under pressure from Fitch, Moody’s and Standard & Poor’s, current Puerto Rican Governor Alejandro Garcia Padilla, not a supporter of statehood, has taken steps to reduce the island’s long-term fiscal commitments. Since taking office this past January, his administration has raised the mandatory retirement age for public-sector employees, required these workers to contribute more to their pensions, and moved new government hires into 401(k)-style retirement plans. Padilla, along with his predecessor, Luis Fortuno, cut a combined one in ten jobs from the public payroll, a major reason for the reduction in the island budget deficit from $2.2 billion to $870 million. Puerto Rican Treasury Secretary Melba Acosta Febo assures investors that her government “has put in place a plan to strengthen the economy for the long term.” One hopes so. The island is running out of alternatives.