“A democracy will continue to exist up until the time that voters discover they can vote themselves generous gifts from the public treasury. From that moment on, the majority always votes for the candidates who promise the most benefits from the public treasury, with the result that every democracy will finally collapse due to loose fiscal policy, which is always followed by a dictatorship.”
Alexis de Tocqueville 1835
As we head into 2014, you may be asking why we are concerned about a small island located in the Caribbean Sea, about a thousand miles southeast of Miami. Geographically, it is a mere speck on the map… practically irrelevant. In fact, 70 islands the size of Puerto Rico could fit comfortably into the state of Texas. However, the debt burden currently burying this economy may eventually send nasty tremors into the United States’ municipal bond market.
Surprisingly, of all the US muni bond funds, a staggering 75% of them are lending money to Puerto Rico, leaving millions of US investors and a large portion of US brokerage accounts exposed to this beleaguered little island. We suspect Puerto Rico will become America’s Greece. If swans could fly this far south, they would without question be the color of night.
2014 Tail Risk
Texas’s state government debt is relatively modest, near $40 billion, or $1,577 per resident. Puerto Rico’s public debt of $53 billion is nearly $15,000 per person, but when we add inter-governmental debt the mountain rises to $70 billion, or $17,500 per person. Throw in a violently under-funded pension and healthcare obligations, the noose approaches $160 billion. That’s $46,000 per person, enough to make one think about trying a swim for Miami.
Quantitative Easing: Deadly Side Effects
Puerto Rico, a mere rectangle 100 miles long by 35 miles wide, the smallest and most eastern island of the Greater Antilles, is the 3rd largest municipal bond issuer after California and New York. That is a mind-blowing statistic. But Puerto Rican bonds are free from all State, Federal and local taxes, a very attractive investment for US investors with a thirst for yield. This is one side effect of low interest rates and quantitative easing coming out of the Federal Reserve; American investors have become this island’s great enabler from the north. Similar to 2007, when investors were reaching for yield in toxic subprime mortgage CDOs, today this song is playing again. This time in Spanish. A colossal reach for yield has enabled politicians in Puerto Rico to run up a dangerous bill, and the music is about to stop.
States with the Most Public Debt vs their Size of Population
California $99B vs 38 million people
New York $62B vs 19 million people
Puerto Rico $52B vs 3.6 million people
Credit Contagion; Toxic Side Effects
A default in Puerto Rico would re-price the entire $3.7 trillion US Municipal bond market, costing states and counties across America billions in additional interest rate charges. Once investor confidence is lost, it’s like losing personal trust, and becomes almost impossible to get back. So far Puerto Rico’s $52 billion pile of bonds were off 20 points in 2013, already costing US investors nearly $10 billion.
An unsustainable, systemic risk debt bomb has been formed. If there was a picture of moral hazard in the dictionary, Puerto Rico’s image would be right there next to Fannie and Freddie, the US government sponsored entities that already received a $180 billion bailout from taxpayers.
The Great Enabler
Why is Greece being forced by the heavy hand of the market to get its financial house in order, while Puerto Rico continues to walk down this reckless road to fiscal destruction? There’s only one reason. The US Congress is their great enabler. In Europe, Germany, as well as the bond market, has had enough with Greece living beyond their means.
Lehman Like Financial Transparency
Politicians can only promise so many goodies as they try to get elected, but in the end somebody has to pay the bill. Why would you lend money to any person, organization or country that doesn’t provide timely information of their finances? There’s less transparency on Puerto Rico’s true financial health than there was coming out of Lehman Brothers in 2008. As someone who wrote the New York Times bestseller on Lehman’s demise, I’m here to tell you, Puerto Rico’s accounting smells to high heaven. Audited financials for the fiscal year ending June 2012 only became available to investors a year and a half late, finally arriving in September 2013. Five years after Lehman, this is outrageous.
One would think a government that spends $10 billion a year on 3.6 million people in such a small place would have low, single digit unemployment figures. Think again. For the last 7 years, 95% of the time Puerto Rico has been in recession. This petri dish of American Socialism is consistently producing 13% – 15% unemployment. With all this “stimulus,” as President Obama likes to call it, the latest jobless figures for October came in at 14.7%, up from August’s 13.9%. How these horrible statistics are allowed to march on is the question no one in Washington is prepared to answer. On top of all the debt, the US taxpayer is sending Puerto Rico $6.2 billion a year in social program funding and has very little to show for it.
300% Water Inflation
It’s hard to believe, over 60% of the Commonwealth’s water is lost through theft or leaks, staring down at the US’s 12% industry average among water utilities. Bills have tripled from $50 a month to $150 over the last 6 years, there’s a growing 25% delinquency rate. In jeopardy on the rise, this cash flow is the life blood traveling to the US in interest for municipal bond investors.
Stopped Looking for Work?
Entitlements and transfer payments from Uncle Sam make up some 40% of total Puerto Rican personal income, with 27% of the citizens on food stamps. Recently, much has been made about the US’s labor force participation rate in free fall at 63%, down from nearly 68% in 2007. It’s a day at the beach in Puerto Rico, with a appalling rate of 41%, many people simply prefer not to work. With a welfare state this big, why even try?
A recent Manpower Employer Outlook Survey reports Puerto Rico’s employers on average do not plan to increase hiring during the first quarter of 2014. By contrast, a net of 16% of US States plan to expand payrolls. The country’s main economic activity index has been in decline for 11 years in a row. In 2013, it is down 5.4% – a whopping 25% off 2005 levels.
Ironically, consumer spending has increased 5% to 6% a year through 7 years of recession. Similar to Greece, 30-40% of the Puerto Rican economy is underground, making tax collection the biggest challenge. Puerto Rico’s fiscal deficit was $2.2 billion in the year ending in June, just a slight miss compared to the $300 million projection the government shared with investors last year. If a publicly owned corporation had these kinds of consistent earnings misses, management would be thrown out of the office, probably to face a firing squad!
Investors need transparency and realistic tax revenue projections from bond issuers. In Puerto Rico, Detroit and Greece, investors have been taken to the cleaners, with promises nobody can keep, but merely hyperbole to sell the next pile of debt to bond buyers in search of income and to keep the dream alive.
The new deficit forecast for the year ending June 2014 is $850 million. Puerto Rico’s government is losing credibility by the day.
2014 $850 Mln (Est)
2013 $2.2 Bln
2012 $1.7 Bln
2011 $2 bln
2010 $3 bln
2009 $3.2 bln
Rising Tensions between Washington and San Juan
In June of 2013, there were $300 million US Medicaid funds to be paid to the citizens of Puerto Rico, but for the first time the payment was delayed. Why? The Puerto Rican Government, with one hand in Uncle Sam’s pocket, changed their nationally sponsored insurance carrier without getting approval from the US Health and Human Services Department. We’re told the US Treasury is investigating, which caused the delayed the payment.
Puerto Rico has lost access to the US capital markets, which is a fancy way of saying most investors have stopped buying the country’s bonds. Now the government is heavily relying on regional bank financing. New private and bank financing in the 5-10 year range is running up at 9%, similar to Greece in 2010, levels which will prove to be unsustainable.
As the government is leaning on the regional banks for financing, the FDIC is creating a possible black hole for themselves, which so far has them on the hook for another $2-3 billion. We’re told in recent weeks they have a SWAT team in San Juan, searching under the hoods of these banks.
As with all distressed situations, we’re keeping an eye on near term debt maturities. Puerto Rico has $507 million of bonds coming due in the next 3 months, and another $700 million that needs to be repaid by June 2014.
The Government Development Bank (GDB) recently repaid Barclays $400 million it had borrowed on a short-term basis when the GDB “planned” to go back to the capital markets. It has to pay another bank another $400 million in December, and another debt of $300 million early in 2014. Even with expected revenues, the payments and others will very much narrow the GDB’s liquidity, according to an official.
In a recent client note, my colleague Robbert van Batenberg of Newedge made an interesting observation. “The Puerto Rican banks are also sensitive to the island’s tenuous fiscal situation. Popular Bank (BPOB) for example has $1.4bl of exposure to the government, of a total loan book of $30bl and First BanCorp (FBP) and OFG Bancorp (OFG) have both about $990ml of total exposure over an $11bl loan and a $6.8bl loan book respectively.”
Puerto Rico’s deficit is $890 million annually, and needs to be brought down to $250 million in order for the Commonwealth to regain access to the municipal bond market. Just like Greece and Portugal, they are shut off, and trust has been broken.
A Fatal Blow
Ultimately, the fatal blow will likely come from the commonwealth’s colossal underfunded pension obligation. At $36 billion, according to Moody’s, is 235% of the tax revenues. This leaves Puerto Rico with an embarrassing 11.2% funding ratio, the worst of all US municipalities. Similar to Fannie and Freddie in 2008, how this situation has been able to go on for so long lies in the dirty hands of politics.
Puerto Rico’s Public Bonds
AA- / AA3 Cofina (Sales Tax Backed) $15.3 Bln
BBB / Baa3 Highway and Transportation $4.7 Bln
BBB / Baa3 Electric Power Authority $9.2 Bln
BBB-/Baa3 General Obligation $10.8 Bln
BB+ / BA1 Aqueduct and Sewer $4.7 Bln
Greece Like Forbearance is Likely in the Cards
The likely outcome will be Greece like forbearance agreement forced on bond holders. In other words, with the approval of Uncle Sam, Puerto Rico lowers the coupon on their debt load to say 3% and extends maturities out to 2030 through 2050. It’s a technical default because when this is put into practice, bond prices drop like a stone. Greece bonds which traded at 100 in 2008, touched 18 cents on the dollar in 2011. The pain for investors could be severe without another bailout from US taxpayers. It’s simple math. Mathematics is not Republican nor Democrat it’s the lurking sword which has no friends, especially in Greece. A 9% interest rate on $70 billion of debt is over $6 billion a year of interest expense for a country with a $10 billion annual budget. Even at 4.5% that’s $3 billion of interest costs, or 30% of the budget without even entertaining the thought of Pension and Healthcare obligations.
Soak the Rich
The territory needs to dramatically cut spending and unrealistic promises, but their solution of choice has been tax hikes in order to close these fiscal gaps. Last year, it raised the top marginal rate from 30% to 39%. The next victim is likely to be the corporate tax rate for multinational companies, which have been lured into Puerto Rico due to its favorable corporate tax rate. Some say raising taxes here is killing the goose that laid the golden egg.
Corporate tax rates going from 4% to 6% will generate an additional $1 billion or 13% more in tax revenues. Some of the multinationals with significant assets in Puerto Rico are Johnson & Johnson (JNJ), Abbott (ABT) and Medtronic (MDT).
On average, these companies were able to reduce their tax rate by 150bp through their presence in Puerto Rico. The corporate tax elasticity in reaction to another hike in the rate is the key to Puerto Rico’s survival. Many US companies have spent millions building an infrastructure on the island, but might be inclined to move if the hikes are too harsh.
Demographic Dead Zones
In the 1990s there were 240,000 Puerto Rican citizens were living in Florida, today that number is over 1 million. In 2000, the commonwealth’s population was 3.8 million, thirteen years later that number in 3.6 million. Nothing like rising taxes and an out of control welfare state to drive people to the exits, deja vu Detroit. The Hispanic population of Puerto Rican origin in the US 50 states and D.C. increased from 3.4 million in 2000 to nearly 5 million in 2013. It now surpasses Puerto Rico’s total population by 30%. Nearly a third of Puerto Rican Hispanics now living in mainland US were born in Puerto Rico, according an analysis of by the Pew Hispanic Center.
Nearly 200 Years Later, these Words Endure
The frustration among the taxpayers has nearly reached a 15 year high, so Puerto Rico must tread carefully in these simmering waters. If they press too hard, could Puerto Rico be on the precipice of destruction the French historian, Alexis de Tocqueville, first wrote about nearly two hundred years ago. To quote him accurately, “the American Republic will endure until the day Congress discovers that it can bribe the public with the public’s money.” Surely, Puerto Rico is much farther along this road than the United States of America. Let’s just hope the possible contagion from this Caribbean chaos stays well clear of American shores. The delicate US bond market, is in no shape for this shock.