If one looks at various sovereign states, it seemingly doesn’t matter that their public debts continue to rise at a hefty clip. The largest ones are considered to have economies that are big and resilient enough to be able to support the growing debt load. Part of the calculus is no doubt the notion that they contain enough accumulated wealth to allow their governments to confiscate even more of their citizens property and income in order to make good on their debts.
Then there are the small and mid-sized states in the EU that are getting bailed out by their larger brethren, or rather, the tax payers of their larger brethren. However, things are different when the territories or municipalities concerned are considered too small and have no such back-up. Detroit was a recent case in point, and it seems that the US territory of Puerto Rico is the next domino to fall. Here is a recent price chart of the Puerto Rico 20 year bond maturing in 2033, which currently yields 10.6% and trades at 46 cents below par:
Puerto Rico’s 20 year bond crashes – click to enlarge.
Amazingly, this junk is still rated ‘investment grade’ by the major rating agencies, even if barely so (both Moody’s and S&P have slapped their lowest investment grade rating on the bonds, with a ‘negative outlook’).
As a good friend of ours remarked, once the inevitable downgrade to junk occurs, there will be a wave of forced selling from bond funds that are statutorily mandated to only hold investment grade bonds. Apparently Puerto Rico’s bonds were extremely popular with US muni bond funds due to their tax exempt status, which increases the effective yield considerably.
Now financial regulators are ‘investigating the Puerto Rico bond strategies‘ of these funds – in what will no doubt be a prelude to a plethora of investor law suits:
“U.S. mutual funds that loaded up on Puerto Rico bonds, including Oppenheimer Funds, are now the target of an investigation by a state securities regulator, who says investors may not have been aware of their exposure to the island’s fiscal crisis.
The probe by Massachusetts’ top securities regulator could spark other investigations because many other state-specific municipal bond funds include Puerto Rico debt in their portfolios, according to analysts. The bonds are exempt from federal, state and local income taxes in all U.S. states, making them attractive to mutual fund managers across the country.
William Galvin, the Massachusetts Secretary of the Commonwealth, said he is investigating three large fund managers, Fidelity Investments, OppenheimerFunds, a unit of MassMutual Life Insurance Co. and UBS Financial Services , to determine how they sold mutual funds with heavy concentrations of Puerto Rico debt and how they disclosed the risk.
"Puerto Rican bonds are like sugar in a bakery product. They are always included. Now the question is just how much and what were investors told," Galvin told Reuters.”
This prompts one question on our part: what the hell were the managers of these funds thinking or doing? Investors in their funds may “not have been aware of Puerto Rico’s fiscal crisis”, but isn’t it a fund manager’s job to be aware of such things? Here we have more proof that there is far ‘more money out there than intelligence to guide it’ to paraphrase J.K. Galbraith. We can thank the Fed for said surfeit of money.
A Long Simmering Crisis
Judging from stories in the press, Puerto Rico’s fiscal troubles were not exactly a big secret. By now officials from the territory are making emergency visits to Washington, presumably hat in hand.
The NYT writes:
“In a meeting with bond analysts in New York on Monday, the president of the Puerto Rican Senate, Eduardo Bhatia, said officials in the United States Treasury and White House had been analyzing the situation carefully, “wondering how they can help Puerto Rico send a very strong signal of stability right now.”
“We are waiting for some sort of an announcement from the Treasury and the White House,” he said without clarification. He also complained that analysts and investors did not appreciate the tough austerity measures that Puerto Rico pushed through in recent months.
Puerto Rico, with 3.7 million residents, has about $87 billion of debt, counting pensions, or $23,000 for every man woman and child. That compares with about $18 billion of debt for Detroit, with a little more than 700,000 people, or about $25,000 for every person in the city. Detroit and Puerto Rico have been rapidly losing population, leaving a smaller, and poorer, group behind to shoulder the burden.
Detroit, at least, was able to seek relief in bankruptcy court, but Puerto Rico is in a legal twilight zone. Territories, like states, have no ability to declare bankruptcy. Another territory, the Northern Mariana Islands, tried in 2012, but its case was rejected. Top Puerto Rican officials say that the territory is not bankrupt and is working through its problems responsibly.”
It seems that the ‘strong signal’ mentioned above is sorely needed. How Puerto Rico’s officials will ‘work through the problem responsibly‘ with a debtberg amounting to $87 billion is not quite clear to us. As to the inability of the territory to declare bankruptcy, bankrupt is bankrupt, whether anyone declares the fact or not.
Puerto Rico’s 20 year bond yield – click to enlarge.
A bailout or a federal takeover of the territory’s financial management are apparently additionally complicated at the moment by the misnamed ‘government shutdown’ in Washington:
“[..] the coming weeks will be critical, and how Puerto Rico comes through depends, to some extent, on factors beyond its control. If its financial problems worsen, it may need some form of sovereign debt relief for which there is no direct precedent — and that would probably be subject to approval by a Congress now paralyzed and focused on a fiscal situation closer to home.
“A lot of people believe that the Territorial Clause of the United States Constitution gives Congress the power to impose control,” said Robert Donahue, a managing director with Municipal Market Advisors, who has been discussing the situation with members of the President’s Task Force on Puerto Rico, a group representing 16 cabinet-level agencies and the White House.
One idea being considered is that Congress might establish a financial control board, perhaps like the one that helped guide the District of Columbia through a turbulent period from 1995 to 2001. One of that board’s first steps was to appoint a financial official with power to override the mayor and City Council. But with the federal government shut down, Mr. Donahue said, “there’s really no path.”
If Puerto Rico were part of the EU, it could at least rely on the fact that the bureaucracy in Brussels never sleeps.
Still, why were bond fund managers so utterly blind to the developing problems? Barron’s reported already in August that the territory was in grave economic and fiscal trouble. In fact, it seems it has been in recession since 2006! In addition to its debt, it has a $30 billion pension hole as well. One positive is that its new government has taken measures to bring the deficit and debt under control, but this may be a case of these measures simply coming way too late in the game.
“Puerto Rico’s debt load would rank third among the states, behind only California and New York. And its debt burden relative to key financial measures—gross domestic product, personal income, and population—is off the charts. Puerto Rico’s debt per capita, for instance, of $14,000 is 10 times the average of the 50 states. In addition to its debt, Puerto Rico has more than $30 billion of unfunded pension liabilities.
The backdrop in the U.S. territory isn’t promising: The economy has been in recession since 2006, the unemployment rate is 13.2%, and the budget has been structurally imbalanced for nearly a decade. The poverty rate is high, government employment accounts for a quarter of all jobs, and transfer payments make up 40% of income. More than a quarter of Puerto Rico’s nearly four million residents receive food stamps.
"There’s a debt spiral in Puerto Rico that will not turn out well unless there is a dramatic turnaround in the economy," says Dan Heckman, senior fixed-income strategist at U.S. Bank Wealth Management in Minneapolis. "We’ve been advising clients to stay away from Puerto Rico. The government is doing all it can, but it has to climb out of a very deep debt hole."
Puerto Rico has taken painful and politically unpopular steps to cut bloated government payrolls, raise taxes, and shore up its badly underfunded pension system. A new government elected in 2012, led by the populist Governor Alejandro García Padilla, is committed to putting Puerto Rico and its various bond-issuing authorities on a stronger financial footing. Default and restructuring aren’t in the government’s vocabulary.”
Maybe “default and restructuring are not part of the government’s vocabulary”, but the markets evidently believe that said vocabulary may have to be enlarged fairly soon.
Puerto Rico’s 15 year yield is at an even higher 11.27% – the yield curve usually tends to invert when insolvency and default are considered increasingly probable – click to enlarge.
We find the Puerto Rico debt crisis quite interesting for three reasons: first of all, it is yet another symptom of the world’s addiction to debt coming home to roost, in spite of the countless attempts to paper the problem over with even more debt. Secondly it demonstrates that systemic risk has not magically ‘disappeared’ since the 2008 crisis, but has merely been shifted around. In the past, many banks would probably have found themselves in hot water, as they likely would have held quite a few PR bonds. These days, investors are bearing the vast bulk of the risk. Of course, in light of the financial system’s interconnectedness, it ultimately doesn’t really matter who is first in line when it comes to financial impairment.
Thirdly, we would point out that this is precisely how wider credit crises tend to begin: one corner of the credit universe begins to burn (in this case, municipal and territorial debt, beginning with Detroit and a few smaller entities), and eventually the flames engulf all or most of it, as many of those hit by losses are forced to sell whatever they can still sell. It is of course possible Puerto Rico’s crisis will blow over without wider-ranging ramifications taking shape – but in a sense it is just be the tip of an iceberg.
Major holders of Puerto Rico’s debt, via Barron’s.
Charts by Bloomberg, table by Barron’s
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