The Cable

Untangling the Puerto Rican Debt Crisis Is Going to Be a Mess

A Puerto Rican default would trigger a mess on Wall Street.

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Puerto Rico is short $73 billion it owes its creditors. Untangling the mess that got the island to this point is going to be a Herculean task, and there’s the potential to lose a lot of cash in the process.

The U.S. government has already denied direct, immediate assistance to San Juan, capital of the American commonwealth. Reaction from the Treasury Department was muted, saying only the island needed a “long-term economic and fiscal plan,” “a sustainable path,” and “an agenda for economic revitalization.” Republicans on Capitol Hill have already said no to a bailout from Congress. They’re also refusing to consider changing the law to allow Puerto Rico to file Chapter 9 bankruptcy, as cities can do, a move that would set up a formal process for those holding Puerto Rican bonds to recoup some cash.

This is leaving some major Wall Street players in the wind. Puerto Rican bonds were in demand for years because they’re tax free. This allowed Puerto Rico to borrow for decades to cover its costs. It’s no longer sustainable, according to a report by former International Monetary Fund economists.

“Puerto Rico faces hard times,” the report said. “Structural problems, economic shocks and weak public finances have yielded a decade of stagnation, outmigration and debt … A crisis looms.”

Those sentiments were echoed by bond rating agencies Standard & Poor’s and Fitch Ratings, who downgraded Puerto Rican debt deeper into junk status Tuesday. S&P says a default is probably inevitable.

If that happens, it would be the largest in the history of U.S. municipal bonds. The island would be shut out of international financial markets and would kick off a lengthy process for investors to try to recover some of what they’re owed.

Complicating Puerto Rico’s economic problems is population flight. Since 2004, more than 5 percent of the population has left, including many who want to live in America.

Investors are now holding a huge amount of Puerto Rican debt, whose value is headed south in a hurry; its bond prices are currently down 12 percent since Monday, now trading at 68 cents to the dollar. It’s not all that different than the housing bubble that caused the stock market to crash in 2008: A number of Wall Street firms are holding assets that aren’t worth what they paid for them.

No one is suggesting that the collapse of the Puerto Rican bubble will have the impact that the housing bubble did. San Juan has $73 billion in unpaid debt; the size of the housing bubble was $5 trillion.

But that’s little comfort to firms like Franklin Templeton and OppenheimerFunds, who together hold about $5 billion in Puerto Rican bonds. Hedge funds like Stone Lion Capital Partners and Knighthead Capital Management also are big holders of San Juan’s plummeting bonds. Bond insurers, including MBIA and Assured Guaranty, are also in line for losses if Puerto Rico governor Alejandro García Padilla can’t find a way to pay his bills.

Without an assist from the White House or Congress, García Padilla is going to have to convince those money managers and hedge funds to put off payments for what San Juan owes or get them to agree to a “haircut,” which would require the bondholders to take far less than what they paid for the debt.

Puerto Rican officials have already tried to get firms including Oppenheimer and Goldman Sachs to agree to give them some flexibility. It didn’t go well.

Earlier in June, the Puerto Rico Electric Power Authority asked a large group of its debt holders for a $2.3 billion cash infusion to help cover a $9.05 billion payment. The proposal was resoundingly rejected.

Photo credit: Joe Raedle/Getty Images

Correction, June 30, 2015: The population of Puerto Rico dropped from 3.8 million in 2004 to 3.6 million in 2015. A previous version of this article mistakenly claimed that 3.6 million people had left the island.

David Francis was a senior reporter for Foreign Policy, where he covered international finance. @davidcfrancis

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