Sinking Under Debt

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By Gaby Lohner

When you think of Puerto Rico, you may think of a warm island paradise where you can guzzle frozen margaritas under a palm tree. Recently, investors and financial analysts have viewed the island nation differently, though – they see it as a sinking ship. Puerto Rico is currently deep in a financial crisis, over $70 billion dollars in debt, and has no clear path out. The island’s government officials have been working with Congress to find a way to restructure and relieve some of the pressure to pay, but no agreement has been reached yet. There are a few important puzzle pieces that must be put together in order to fully understand how an island of 3.5 million has accumulated a debt bigger than that of Detroit at the time of its bankruptcy.

The island has been in a depression for upwards of a decade, even before the Great Recession started in the states. In 2012, in order to help jump start an economy in which around 45 percent of people lived in poverty and companies and people were actively fleeing, Luis Fortuño, then the island’s governor, passed Acts 20 and 22. These pieces of legislation attempted to incentivize wealthy Americans to move to the island through tax laws. Any Americans who moved to Puerto Rico, lived there for six months, and brought a company with them would pay no federal income or capital gains taxes. So while rich businessmen and women moved in to the swanky districts such as Condado, they brought little or no tax income to the island. In 2014, Puerto Rico’s Department of Economic Development and Commerce recorded 250 “high net worth individuals” who moved to the island, joining the 151 who arrived in 2013. New apartments have since been built, shopping has expanded, and many people are loving life in perpetually sunny Puerto Rico, but the island has yet to benefit in an impactful way.

While all of this was happening, Puerto Rican bonds, which were frequently included in mutual funds for average American citizens (often unbeknownst to them) and thus very popular, were downgraded to junk status due to concerns about the government’s ability to pay. Seeing an opportunity to profit from the junk bonds, a type of bond that is classified as being high-yield and high-risk, a certain group of investors who specialize in “distressed assets” were essentially buying the island’s debt. This situation may be confusing, but basically they were buying these low-rated, risky bonds, knowing that they would almost positively be paid back. The reason they knew this is because of the structure of the Puerto Rican constitution. There are two important features of the Puerto Rican constitution when it comes to this matter. The first is that the general obligation bonds, valued at $13 billion, are guaranteed under the constitution, so creditors are required to be paid before the government payroll. This means that the government has to pay back the owners of these bonds before it pays for normal government operations such as paying teachers and other municipal employees. The second important element is Puerto Rico’s inability to declare bankruptcy. While this is an option within all of the 50 states, it is prohibited to invoke Chapter 9, the bankruptcy clause, within the territory. While in the United States bankruptcy is a safety net behind businesses and state governments, outside of the states it does not carry much value. If a sovereign state declares bankruptcy, there isn’t any manual to follow on what happens next – it is a portrayal of the severity of the situation, a statement that all other resources have been exhausted.

Many politicians are pushing to pass a law allowing the filing of bankruptcy, claiming that the Territorial Clause in the US constitution gives Congress the capacity to do so. All the filing really means is that the island would be able to reform and restructure the debt in an official manner while protecting taxpayers. So far, the notion of giving Puerto Rico the ability to declare bankruptcy has divided Congress. Some are trying to prevent the movement, saying that it is possible to restructure without an official declaration, and that declaring it will not resolve the problem entirely. Others believe that bankruptcy is a protection mechanism that the island should have the opportunity to use. Speaker Ryan gave the House Subcommittee on Indian, Insular and Alaska Native Affairs the task of drafting legislation that would allow Puerto Rico to restructure without needing to go bankrupt earlier this year, setting a deadline for March 31, though it is doubtful whether the committee will meet the deadline.

Accompanying all of these issues are structural problems within the big corporations on the “isla de encanta,” the “island of enchantment.” One of the biggest and most baffling portions of debt owed by the island is the the Puerto Rico Electric Power Company, Prepa. For an example of the questionable practices used by the government-owned corporation, you can look to the west coast of the island, where a town called Aguadilla lies. In Aguadilla, there are 19 restaurants, a hotel, a water park, a baseball stadium, and, strangely enough, an ice-skating rink, which are all state owned. Enter Prepa, which decided around twenty years ago to help the struggling town by providing electricity to all of these entities. Prepa has slowly been sinking deeper and deeper into debt, having to borrow billions of dollars in order to survive. Regrettably, on top of Aguadilla, many government-owned enterprises, and some additional businesses all are receiving free power from Prepa. These actions have contributed $9 billion of the $72 billion in debt. This number may seem small in comparison to the total amount owed, but by itself it is quite impressive. While one may think the easiest solution is just to make these local governments start paying, this is a cultural and governmental norm in Puerto Rican society, and therefore it is hard for the government to snap its fingers and change it.

(Photo Credit: New York Times)
(Photo Credit: New York Times)

The Supreme Court began hearings related to this crisis on March 22. The Puerto Rican government is asking that the Court overturn a decision made in July 2015 stating that the public entities of Puerto Rico are banned from restructuring debt without the approval of all of their creditors. If this appeal is granted, Puerto Rico can take big steps in restructuring the massive debt that has been accrued by its public utilities such as Prepa. Congress is simultaneously working on a legislative package to aid the island, despite fundamental differences in opinions between the Republicans and Democrats working on the committee. Puerto Rican officials have warned of impending defaults on interest payments if aid or the ability to restructure isn’t granted by early summer.

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