The Curious Case of Puerto Rico, And Why Default Poses A Risk To The U.S.

06/30/2015 06:00 am ET | Updated Jun 30, 2015

WASHINGTON -- U.S. lawmakers have no firm plan to help more than 3 million American citizens living 1,000 miles off the coast of Florida under a government staring down the barrel of a $73 billion debt crisis.

Those U.S. citizens live in the territory of Puerto Rico. Thousands of them are fleeing each month to the U.S. mainland in the search of economic opportunity, compounding the island’s financial crisis.

Puerto Rican Gov. Alejandro Garcia Padilla put it bluntly on Sunday, admitting that the island’s “debt is not payable.” Garcia Padilla told The New York Times in an interview that if the government cannot get the economy to grow, Puerto Rico “will be in a death spiral.”

Garcia Padilla’s comments come days before Puerto Rico’s government-run electric utility, known as PREPA, must make a $400 million debt payment. The island’s debt, owed to a complex array of creditors, amounts to more municipal bond debt per capita than any American state. PREPA’s payment is just one of many due in the coming months.

For residents, the financial troubles mean higher energy bills, a crumbling infrastructure, and a middle class that is fleeing in droves.

If the impact on Puerto Rico’s citizenry isn’t enough to spur action by the U.S. government, or by the Wall Street hedge funds that hold a significant stake in the island’s debt, maybe the potential effect of a default on mainland Americans will do the trick.

A default by Puerto Rico would roil the municipal bond market -- typically a low-risk arena -- leaving retirement funds, pensions and institutional investors "massively exposed," explained Dante Disparte, founder of the capital management firm Risk Cooperative.

“A $73 billion write-off has a potential to bring down many more aspects of the economy than we might let on, because we are trying to treat it like it’s isolated and that it’s an island, but it’s a dollar-denominated economy. It's part of the U.S., and the firms to whom that debt is owed may very well be the firms managing our grandparents' pensions and our own retirement plans,” Disparte said.

In Puerto Rico, “what it produces is a tragedy of the commons," Disparte, who was born and raised on the island, said in an interview. Every time he visits, Disparte said he sees the effects -- an increasing number of vacant properties.

“When you are playing with things this large and this systemic, you need kid gloves and delicacy and order -- not, ‘It doesn’t matter to me. Let’s just let Puerto Rico fall off the cliff,’” Disparte added.

The White House says it's doing all it can to help the island, despite months of remaining relatively mum.

In April, Treasury Secretary Jack Lew called on Puerto Rican leaders to develop a “credible” budget for 2016 and a long-term plan to reduce debt.

On Monday, after news circulated that Puerto Rico would not have the money to meet the July 1 payment deadline, White House spokesman Josh Earnest played up the administration’s commitment to helping.

"There's no one in the administration or in D.C. that's contemplating a federal bailout of Puerto Rico,” Earnest said. “But we do remain committed to working with Puerto Rico and their leaders as they address the serious financial challenges that are currently plaguing the commonwealth of Puerto Rico.”

Pressed on possible further action, Earnest cited an interagency task force the administration launched in 2013 to offer expertise to the island’s leaders. Earnest acknowledged Puerto Rico’s inability to restructure its public debt under bankruptcy, as municipalities in the mainland are allowed to do.

“So there are strong merits to having an orderly mechanism for Puerto Rico to manage the financial challenges of its public corporation if needed and so we’ve urged Congress to take a close look at this particular issue,” Earnest said, hinting at possible White House support for expanding Chapter 9 bankruptcy to Puerto Rico. “Essentially this means that a Chapter 9 scenario that would be available to all the 50 states is not one that is currently to Puerto Rico, and that is something only Congress can change.”

Garcia Padilla remained steadfast in a recorded address broadcast Monday evening, outlining a plan that would allow the island to avoid “choosing to pay police officers and school teachers” or “our debt.” While preaching shared sacrifice, Garcia Padilla made an impassioned pitch for Washington lawmakers to “take concrete action in this crisis. Concrete action now. Action to approve much needed changes to Chapter 9 of the bankruptcy code so that Puerto Rico qualifies for the same protections available to other cities or states.”

But Congress is nowhere near moving legislation that would grant Puerto Rico the same bankruptcy protection that Detroit used in 2013.

House Judiciary Committee Chairman Bob Goodlatte (R-Va.) has said allowing Puerto Rico to use bankruptcy may have large economic consequences and deserves close examination. A committee aide said Goodlatte and other members travelled to Puerto Rico this month to meet with local officials and stakeholders. The committee hasn't met on the issue since February.

Former Puerto Rican Gov. Anibal Acevedo Vila said the U.S. government has a responsibility to help Puerto Rico.

Acevedo Vila has long defended commonwealth status for Puerto Rico, but has recently argued that the official U.S. position since the 1990s has been to treat the island as a territory.

“My argument is look, you have a political responsibility, you have a social responsibility, you have a moral responsibility, but at the end of the day, you might even have a legal responsibility," Acevedo Vila said in an interview with The Huffington Post this month. "Because if the official position is that we are still a territory, and the day comes and we default -- and I’m not arguing that we should default -- I’m saying that that day might come soon, and if that day comes, bondholders are going to sue the government of Puerto Rico for sure, but they might sue the U.S. government.”

He added: “I’m not using this argument to threaten the U.S. government. It’s just to create more conscious[ness] that this is also a U.S. government problem, and not just the problem of the people of Puerto Rico, and we all have to sit down and find a solution to this crisis.”

Acevedo Vila’s prediction of a default triggering lawsuits is not farfetched. Matt Faber, of Municipal Market Analytics, said things will get more complex and “decidedly uglier” should the island default.

Lawsuits already are scattered across the debt landscape. PREPA bondholders, including Franklin Templeton and Oppenheimer funds, sued Puerto Rico in 2014 after the island passed legislation granting the commonwealth the ability to restructure its debt and file bankruptcy. The measure ultimately was struck down in court and is currently on appeal.

“There are lawsuits here that would happen almost immediately between bondholders and PREPA, between one group of bondholders and other bondholders, and between bondholders and their brokers-slash-dealers, or whoever bought the bonds for them," Farber said. "So there’s a potential for lawsuits going all kinds of ways. And then because it’s a utility, there’s a potential for court intervention, because bondholders may sue to impose a receiver who would take effective control away from PREPA’s current manager and put it in the hands of someone appointed by the court.”

While the storm gathered, analysts like Faber don't see an easy solution.

“The status quo has a lot of uncertainty,” Faber said. “It’s hard to see anything different, because it’s hard to see Congress passing a law to impair bondholders in a similar way that the president did with GM bondholders.”

In the General Motors bailout, the Obama administration led expansive restructuring, enticing a majority of bondholders to agree to swap GM bonds for a stake in a government-financed iteration of the company paying much lower returns.

“They would really need an act of Congress to do much to do really anything that’s meaningful," Faber said. “When you have the Republicans who are in charge of Congress are extreme anti-bailout ... there’s almost no chance.”

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