Cyprus in the Caribbean

Could Cyprus happen over here?

Many folks look at their problems and say, “Nah.” We don’t have an outsized banking system mostly funded by foreigners, and we’re working with our worst problems. Meredith Whitney was wrong; the muni market didn’t see dozens of major bankruptcies with hundreds of billions of losses, right?

Well, maybe.

One glaring issue in an otherwise sound municipal credit universe is Puerto Rico. The Commonwealth has a population of 3.7 million, of which only about a million have jobs, and over 40% of which lives below the poverty line. Its public debt is enormous: almost $68 billion, or more than $18 thousand for every man, woman, and child. By contrast, the most indebted US state, Connecticut, has $5400 per person in debt.

But the main problem in Puerto Rico is the pension system. Many states have underfunded their pensions—New York by 10%; Massachusetts by 27%; New Hampshire by 42%, which is pretty bad. But Puerto Rico’s pensions system is 93% underfunded, and probably will run out of cash sometime in 2014. When that happens, look out!

Because Puerto Rico bonds are tax-exempt in all 50 states, they are widely held in many state-specific and national tax-free mutual funds. But the Commonwealth’s fiscal difficulties have them dancing with a downgrade. Both Moody’s and S&P have PR on the edge of a junk bond rating; if they do become non-investment grade, there will be a lot of soul-searching and forced selling by muni investors. Is Puerto Rico too big to fail?

Any default is unlikely—the Commonwealth is constitutionally required to satisfy their debt obligations before paying anyone else. The problem is that over 40% of the labor force works for the government. Are they going to stand in line behind Nuveen and Fidelity? And if the island does default, it will shock the financial world.

Think Cyprus can’t happen over here? Think again.

Douglas R. Tengdin, CFA

Chief Investment Officer

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