Forget Greece, Puerto Rico Is On The Verge Of Default

With the financial world fixated on Greece’s debt-driven meltdown, Puerto Rico announced this week that it can’t pay its $73 billion in debt. Compared to Greece’s $353 billion in debt, Puerto Rico’s $73 billion doesn’t sound so big. On a per capita basis, it’s about a third less than Greece, but appearances can be deceiving. Puerto Rico is in deep, deep debt owing actually much more than $73 billion, with some estimates as high as $100 billion.

The Commonwealth of Puerto Rico is a United States territory located in the northeastern Caribbean, east of the Dominican Republic, and west of the US Virgin Islands, with a population of apprx. 3.6 million people. Puerto Rico has a small population that is similar to Connecticut, but it has about the same debt load as New York State, a huge state economy.

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So how did Puerto Rico get to this point? First, its economy has been mired in a recession since even before 2008 – reportedly for the last nine years. The economy has been shedding jobs for years. Residents have been leaving the island for years as well. Many of its working-age population have chosen not to work, opting to live on overly generous government benefits and welfare programs. It’s a familiar picture, unfortunately.

Puerto Rico has all the symptoms of a welfare state gone wrong. The island’s lack of competitiveness can be seen in the scant growth of its low-skill and low-wage industries, such as tourism. The number of hotel beds on the beautiful island has changed little since the 1970s, and tourist arrivals are down over the past decade.

In short, Puerto Rico is a basket case, and it poses a real financial threat to the US. Unlike in Greece where most of its debt is now owned by the European Central Bank and the International Monetary Fund, most of Puerto Rico’s debt is sold in the US and is held by American interests including banks, mutual funds, ETFs, hedge funds and individual investors.

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Over 20% of US bond mutual funds own Puerto Rican bonds, according to data from Morningstar. The majority of the funds with exposure are municipal bond funds or high yield bond funds. Puerto Rico’s bonds have municipal status, meaning they are tax exempt. That’s why a lot of US retirees buy them.

In total, US bond mutual funds hold about $11.3 billion of the island’s debt. Another roughly $15 billion is held by hedge funds. The remainder of the debt is held largely by US banks and individuals – mostly American and Puerto Rican investors.

While I could not find exact figures on how much of Puerto Rico’s $73 billion in debt is owned by US individual investors, it would be safe to assume that American interests own at least half of PR’s debt.

Puerto Rico’s bonds have also been demoted to “junk” status by the major rating agencies. As such, many insurance firms and pension funds can’t hold Puerto Rican debt anymore. But high yield bond funds can invest in debt that is of poorer quality, so Puerto Rican bonds are very common in them.

Among the funds that hold Puerto Rican debt, some of the largest are run by Oppenheimer Funds and Franklin Templeton. For example, the Franklin Double Tax-Free Income Fund has nearly half of its investments in Puerto Rican bonds. The point is, if you have money in high-yield bond funds, you should check out how much they have invested in Puerto Rican bonds.

For all the reasons noted above, the Puerto Rican debt crisis is much more troubling to the US than the Greek melodrama. And it’s only going to get much worse in the months and years ahead.

In closing, I should note that Puerto Rico had several debt payments to make by Wednesday of this week, and it made them according to the government. The island country paid back about $1.3 billion of debt this week.

While that was welcome news yesterday, Puerto Rico still has a huge debt load to repay in the coming months and years. Puerto Rican Governor Alejandro García Padilla has called his country’s debt dilemma a “death spiral” and warned that it’s too much to pay.

Finally, you should know that Puerto Rico, as a territory of the US, does not have the ability to declare bankruptcy. However, on Monday night, Puerto Rico’s Governor Padilla boldly asked Congress for the ability to declare bankruptcy. A Puerto Rican default would be the largest in the history of US municipal bonds.

While I can’t know what Congress will decide, Puerto Rico could well be our next financial crisis.

I hope everyone has a happy 4th of July as we celebrate Independence Day!

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