Commonwealth of Puerto Rico – Just Another Moral Hazard

By Richard L. Wottrich, CEO & Senior Consultant, International Services

December 7, 2015, Chicago USA

Puerto Rico has been in the news lately, but its financial problems have been building for years. If Puerto Rico were just another Third World country we wouldn’t even notice. But Puerto Rico is a U.S. unincorporated territory, hence its people are U.S. citizens. They can enter the U.S. Mainland without a green card – and they do. Who wouldn’t with 12.4% unemployment and one third of the population on welfare? With no jobs, Puerto Rico’s population of 3.62 million is shrinking, as is its tax base.

We notice Puerto Rico because of the magic of its territorial status. Its government can issue U.S. double- and triple-tax free bonds, which can be legally bought by single-state municipal funds stateside. And they do. Puerto Rico’s recent bond yields are 12.3%. They are tax-exempt from federal, state and city taxes on the mainland. Standard & Poor’s rates Puerto Rico bonds as CCC-, and Moody’s rating is Caa3; both below investment grade.

The Puerto Rican government took these bond proceeds for years to install a lavish safety net. It has borrowed $72 billion plus another $33 billion in unfunded pension promises. This works out to over $25,000 of debt for each of its citizens, greater than its per-capita GDP of $23,840. Puerto Rico’s annual fiscal burden is equal to five times its annual tax proceeds. Puerto Rico GDP is $101.5 billion, which would be 60th in the world if it weren’t a U.S. unincorporated territory.

Governor Alejandro Garcia Padilla recently started a political game of chicken, announcing that the government could run out of cash and will pay for essential services over creditors. This shock to markets came a week after the Obama administration proposed giving the commonwealth unprecedented authority to restructure its entire debt burden through bankruptcy protection, a proposal the governor endorses. It is no stretch to imagine coordination of these pronouncements.

Wall Street makes big money on Puerto Rican bonds. In 87 bond deals since 2006, Puerto Rico sold $61 billion of bonds which resulted in fees to Wall Street firms of $1.4 billion, an average fee of 2.3% ($23.00 per $1,000). The fees charged were higher than those assessed on other financially troubled US states and cities. In fact, according to Reuters, banks such as UBS were paid gross spreads averaging 31% higher than spreads charged to Detroit.

For comparison, the fees that bankers are paid to underwrite U.S. mainland municipal bonds have been declining since financial markets started their recovery in 2009. Through May 23, 2013, state and local governments have paid underwriters on average $5.16 per $1,000 (0.51%) of bonds sold this year, according to Thomson Reuter. That number has come down almost 17% since it peaked at $6.21 (0.62%) in 2009, when deals were riskier to underwrite and fewer banks were competing for business following the financial downturn.

UBS, one of the major underwriters of Puerto Rican debt, not only charged fees to underwrite Puerto Rican bonds, they then packaged these bonds into their own “closed end mutual funds”, charging retail investors a “front end load” of 4.75 % and annual fees of 1%.  This represents a total load of 8.05% ($80.50 per $1,000). No wonder Wall Street loves Puerto Rico!

This is a classic example of moral hazard, as Wall Street understands that the federal government will probably step in to bail out Puerto Rico in the event of default. Last week the U.S. Supreme Court agreed to hear Puerto Rico’s bid to reinstate a law that would allow restructuring of the debt-burdened U.S. territory’s public agencies. This is a mind-numbing potentiality that could lead to all 50 U.S. states gaining the right to bankruptcy – and federal taxpayer bailouts.

Of those Puerto Ricans who have stayed in country, only one fourth have jobs, and one fourth of them work for the government. Private-sector employment is 647,000, just 17.3% of the island population. In the U.S. private sector jobs account for 42% of the population. Over 1.3 million people received food stamps in Puerto Rico each month in fiscal year 2013 (34.8% of the population).

A democratically elected bicameral legislature governs Puerto Rico, but the U.S. Congress controls many fundamental aspects of Puerto Rican life. In November 2012, a non-binding referendum resulted in 54% of Puerto Ricans voting to reject its Commonwealth territorial clause of the U.S. Constitution. Among respondents to a second question about alternatives, 61% voted for statehood as the preferred alternative to the current territorial status.

This proves that Puerto Rican citizens do not know how good they have it. Puerto Rico cannot yet declare bankruptcy, just as a U.S. state cannot. In fact, its legal status as a “ward” of the U.S. Congress implies federal bailouts anytime it requires funding. Puerto Rico has all the benefits of being nanny state without actually being a nanny state. This too is the essence of a moral hazard.

Puerto Rico is the only significant U.S. unincorporated territory, followed by the much smaller islands of Guam, the Northern Mariana Islands, and the United States Virgin Islands. Thank God for small favors.

Richard Wottrich, richard.wottrich@dsiglobalview.com