STUMP » Articles » Puerto Rico: After the Default » 8 January 2016, 03:53

We started the week with a de facto default, so let’s see what’s going on with Puerto Rico.

PUERTO RICO: PLAYING FOR TIME

So, Puerto Rico made some of its debt payments on Monday, and let others go entirely unpaid. I was wondering where the money to pay some of the debts came from.

Krist Culpepper explains:

The Puerto Rican government has also explained how it was possible to pay the bonds that it did pay, as a means of making clear that these were some of the last payments it would be making on the debt. The government has been “clawing back” revenues from other bondholders to pay the debt service on the general obligation bonds. The government also tapped nearly $383 million of debt service reserve funds to make the payments it did, out of approximately $1 billion due. This means the commonwealth was short almost half of what it needed to make its required payments once other issue components were netted out and the amount it did default on is taken into account.

She goes on to explain what a debt reserve fund is. She quotes this Bloomberg piece, and then sarcastically remarks:

Yep, these will be the first defaults in the history of the bond market that do not trigger litigation. Incidentally, if Mr. Palmer had read Bloomberg days before, he’d know that Ambac and FGIC are already preparing lawsuits. Some analysis of municipal bond insurers.

Guess what?

LAWSUIT TIME!

From the WSJ:

Bond Insurers Sue Puerto Rico for Redirecting Debt-Payment Funds
Lawsuit by units of Ambac Financial Group and Assured Guaranty comes after commonwealth missed $37 million in bond payments

Units of bond insurers Ambac Financial Group Inc. and Assured Guaranty Ltd. Thursday challenged Puerto Rico’s move to pay some investors at the expense of others, escalating the U.S. commonwealth’s struggle with creditors.

The insurers, which back almost $8 billion of debt from the island between them, asked the U.S. District Court for the District of Puerto Rico to block the move, arguing it violates the U.S. Constitution. Puerto Rico this week missed about $37 million in bond payments, after redirecting money collected to pay some debt toward bonds with stronger legal protections.

The commonwealth “is disregarding the priorities of its own Constitution and the rule of the law​,” Dominic Frederico, Assured​’s chief executive officer, said in a statement. “This confiscation of revenues pledged to bondholders is illegal.”

Not having a legal bankruptcy process means there will be multiple, separate lawsuits.

PUERTO RICO AND DEMOGRAPHICS

One item I keep beating about Puerto Rico (and Chicago) is the loss of population (or, rather, shrinkage of the tax base). Here are two interesting pieces on that.

Here is Munilass/Kristi Culpepper again:

I have written a number of articles arguing that haircuts for all of Puerto Rico’s bondholders — general obligation bondholders included —are inevitable. I believe the municipal bond market is undergoing a paradigm shift that will end in market participants realizing two things: (1) there is no such thing as a pledge of unlimited taxation, and (2) this illusory pledge enables governments to overextend themselves financially.

Aside: I agree with everything in that paragraph.

To understand how the general obligation pledge enables over-borrowing, one must first recognize that a tax base is more than numbers in some analyst’s spreadsheet. It is a collection of real people and businesses that are in control of their own destiny. While the opportunity to participate in a unique culture might add some traction, there is only so much pressure that a government can place on residents before they choose to relocate. Detroit, Illinois, and Puerto Rico are excellent examples of residents “voting with their feet.”
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Second, while many acknowledge Puerto Rico’s sizable and persistent population loss, it is a largely unexplored topic. And it is a very important topic. While the threat of legal chaos associated with defaults speaks to the issue of restructuring too late, demographic trends will help us understand what constitutes restructuring too little.
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What does Puerto Rico’s tax base even look like anymore?
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Here are some important trends Stone identified that I think will materially factor into Puerto Rico’s ability to service its debt going forward and on the trajectory of government expenses.

1. Within the near term, Puerto Rico will be experiencing both a large outmigration and a natural population decline.
2. Puerto Rico is primarily losing its younger population, with almost 3.5% of its young adult population leaving in a year.
3. The people leaving tend to be in families, as the trend in 20 to 34 year-olds matches the trend in 1 to 4 year-olds.
4. Net migration for Puerto Ricans aged 60+ has not changed.
5. Stone believes that with these trends, Puerto Rico’s population will begin to decline a lot faster than people expect. The commonwealth’s mortality rate will be rising while birth rates will fall. He projects Puerto Rico’s population could potentially decline by up to half a million people by 2025. This might be a concern if you are holding Cofina debt, as substantially all of it is back-loaded.
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These observations suggest two things to me:

1. It will take drastic haircuts to Puerto Rico’s debt to bring the government’s expenses in line with the structural changes occurring on the island. Textbook budget analysis (assuming historical trends regarding revenues and expenditures will remain relevant) will likely fail here.

2. Any “solution” that increases the cost of living or doing business in Puerto Rico will likely accelerate an already dire situation. Again, there is no such thing as unlimited taxation.

She refers to another piece, which really digs into the demographic changes in Puerto Rico. Check it out.

I will grab one graph from the piece to give you an idea:

This is what the author, Lyman Stone, has to say about that graph:

As is quite clear, migration is declining at the fastest rate for the youngest Puerto Ricans. And what an rapid rate of decline it is! Losing almost 3.5% of your young adult population in a year is an astonishing decline. It’s the largest such decline in 2014 of any state except Alaska (where the data is really flukey anyways). And apparently, those 20–34 year olds are taking their kids with them, hence the parallel trend among 1–4 year olds. Migration for 5–19 year olds falls between young parents and middle-age migration, again suggesting the people leaving Puerto Rico tend to be families. Just to be sure, I checked rates by family status too: sharp declines for all categories except widowed… and migration among widowers actually improved. Divorced people had the smallest decline, separated the most, married and never married about equal.

Meanwhile, net migration for those 60 and older is unchanged. Retirees are pretty much staying in place.

And we know it’s so easy to get money from retired people to pay for governmental bonds, right?

I do wonder who are those domestic holders of PR bonds, don’t you?

Puerto Rico bonds offered high returns and tax-free income. And there was little chance, his broker assured him, that the government would default on its debt.

So Mr. Steinberg went all in, investing more than 85 percent of his retirement savings in funds with large concentrations of Puerto Rico bonds.

“They told me this was safe,” said Mr. Steinberg, a 64-year-old mathematics professor at the University of Puerto Rico, “that the legal protections to repay the bonds were strong.”

I doubt Mr. Steinberg is planning on moving. But it seems to me he made a poor choice in his retirement asset allocation.

And there are fewer younger people to stick around to pay for those bonds.

And I doubt the federal government is going to make good on the bonds of a different profligate government.

So…. more to come. Later. That’s for sure.

Compilation of Puerto Rico posts

The State of the States: a Compilation