Are the lights going out in Puerto Rico?
Photo: Joao Pacheco. Source: Picjumbo
Today the Puerto Rico Electric Power Authority (PREPA) is scheduled to pay $400 million in principal and interest to bondholders. It’s unlikely that they have cash to do this. They drew down their reserve account a year ago, and haven’t built it back up. In fact, the bond’s trustee issued a notice a couple weeks ago, warning that they don’t have the funds to make the payment.
The default is likely to send shock-waves through the municipal bond market. Now, defaults are routine in financial markets. It’s why creditors get paid interest on loans—there’s always a chance you won’t get your principal back. And we have courts to sort out the claims when things go wrong. Municipal defaults are less common that corporate filings, but there’s still a settled bankruptcy regime. In 2013 Detroit filed Chapter 9, adjusted its debts, and moved on.
But Puerto Rico is a special case. It’s not a State, it’s a Territory. Its own Constitution guarantees the priority of their General Obligation debt, but you can’t pay back money you don’t have. And most of Puerto Rico’s $72 billion in debt was issued by special territorial corporations, not the Territory itself. So, as you might say on Facebook, it’s complicated.
At this point many analysts start going into mind-numbing detail about special purpose clauses and payment waterfalls that make me need to get up and move around. But the bottom line is this: Puerto Rico’s total debt is greater than 70% of its declining economy. The median US State debt to GDP ratio is less than 16%. And that doesn’t even consider PR’s pensions, which are less than 20% funded.
Puerto Rico Real GDP. Source: World Bank, Bloomberg
Up to now, the Territory has tried to borrow its way to prosperity, filling budget gaps with more obligations. But that doesn’t address the underlying issue. Their economy has been contracting every year since 2006, a date that coincidentally corresponds with the expiration of a clause the US tax code that favored US corporations with subsidiaries there. The IRS closed the loophole, PR’s economy declined over 15%, and Governor Padilla has said, “No mas.”
What’s next? There’s never only one cockroach. PREPA’s default will be followed by problems among all the other special corporations. Even its general obligation debt may face challenges. The island is trying to work out a deal with the major bondholders, but negotiations are likely to be tough.
Get ready for a long, hot summer. If you want to know who’s next, just watch where the vultures are gathering.
Douglas Tengdin, CFA
Charter Trust Company