Market Extra: Puerto Rico has more than $70 billion in debt because of this

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Puerto Rico, and domestic entities linked to the U.S. territory, owe creditors more than $70 billion. A double-whammy of devastating hurricanes in recent months, Maria and Irma, only exacerbated the plight of the Caribbean island that sits about 1,150 miles south of Florida. Even before the natural disasters had struck, former Gov. Alejandro García Padilla (who was succeeded by Gov. Ricky Rossello) declared its situation a “humanitarian crisis.”

Why is Puerto Rico in such bad economic shape?

More than a decade of economic decline and ballooning deficits, amplified by an exodus of the territory’s best and brightest, including doctors, to the U.S. has dealt a heavy blow to the Puerto Rican economy. It has been in a recession, defined as at least two consecutive periods of declining growth, since 2006.

  • The Commonwealth had an unemployment rate of 12% before the hurricanes, compared with an unemployment of 4.4% for the U.S., as of August.
  • 43.5% of its residents live below the poverty line, according to U.S. Census Bureau data, more than double that of Louisiana and Mississippi.
  • Its population is 3.4 million as of July 1, 2016, representing a decline of more than 8% since 2010.
  • The island’s debt load represents $12,000 per capita, with its debt representing more than three-quarters of its annual gross national product, which would make it one of the most indebted countries in the world.
  • As a U.S. territory, the island uses the U.S. dollar, That means it can’t devalue its currency in a bid to improve competitiveness.

How has Puerto Rico been funding itself?

Puerto Rico lost access to the traditional municipal bond market in February 2013 after ratings firms downgraded it to so-called junk status. That has made it more expensive for the country to fund itself because lenders demand a greater return to lend to creditors considered on the lowest rung by credit-ratings firms. In March 2014, the island sold $3.5 billion in debt, with an 8.5% coupon, entirely to hedge funds.

Since then, Puerto Rico has been employing severe belt-tightening measures, including delaying payment of tax refunds, liquidating pension and other compensation funds and deferring payments on a host of other obligations.

A third of the island’s money had been used to service its debt as of 2016. At the end of 2014, three public pension funds held just $2 billion in assets against a combined estimated pension liability of $46 billion.

Is all that sustainable? No

Puerto Rico filed for the equivalent of bankruptcy on May 3, with the aim of shrinking its burdens by $123 billion, which include a host of general obligation bonds.

Because Puerto Rico isn’t technically a municipality, Congress invoked a law that places the debtor and its creditors before a federal judge in San Juan to go through a restructuring process known as Title III—a pseudo bankruptcy filing for the U.S. territory, which isn’t eligible for chapter 9 bankruptcy as U.S. municipalities are.

What does Puerto Rico owe?

  • $17.8 billion in so-called general obligation bonds
  • 17.6 billion in obligations issued by Puerto Ricos Sales Tax Financing Corp.
  • $9 billion in debt from Puerto Rico’s Electric Power Utility Authority, known as PREPA
  • $52.2 billion in pension-related debt
  • $21 billion in other obligations linked to utilities and other agencies

How did Hurricane Maria affect this ugly situation?

Moody’s Analytics estimates the damages from Hurricane Maria could result in a price tag as high as $95 billion. Moreover, the means by which to services its debts—its people and its infrastructure—are ravaged, or at least severely under strain, in the wake of the hurricanes. Hurricane Irma also struck the island, but Maria delivered the most severe hit.

Who are Puerto Rico’s creditors?

A mix of hedge funds, mutual funds and retail investors, many of whom are Puerto Rican residents, are holders. The hedge-fund groups, most vocally, have been ensnared in tense negotiations with Puerto Rican officials and the U.S. government, which designed an aid package, known as Promesa, or Puerto Rico Oversight, Management and Economic Stability act, to help facilitate a way out of the island’s dilemma. Promesa offers the territory a largely out-of-court process, known as Title VI, that focuses on financial debt and “relies on a collective action mechanism to bind dissenting creditors to the agreement of the debtor and a supermajority of its creditors to restructure its debt.”

Many creditors are worried that any agreement will result in steep cuts on their principal investments.

Cate Long, founder of research firm Puerto Rico Clearinghouse, told CNBC on Wednesday that 75% of the territory’s debt is held by retail investors. The remainder is held by hedge funds, including Aurelius Capital Management and Autonomy Capital.

Other holders include via various entities, according to Morningstar:

  • Goldman Sachs
  • BlackRock
  • T. Rowe Price
  • OppenheimerFunds
  • Franklin Templeton

What’s next after President Trump said the debt should be wiped out?

“We’re going to have to wipe that out. You can say goodbye to that,” said President Donald Trump in response to questions about the fate of San Juan’s obligations. However, there are serious questions about the path forward for Puerto Rico and how much the government can do to alleviate its fiscal problems.

Whatever happens, it is likely to be a very complicated matter.

Puerto Rico Treasury Secretary Raul Maldonado told Bloomberg that the country will face a government shutdown on Oct. 31 without funding from Congress. He said he has asked for aid totalling $6 billion to $8 billion to keep the government going “for a few months.“ Lack of funding means Puerto Rico’s hurricane recovery efforts would also be halted, he said, in an interview that published Thursday.