Puerto Rico Is In Serious Trouble. Here's What You Need To Know.

2016 will likely bring more financial misery for the beleaguered island.

03/01/2016 7:16 AM AEDT | Updated 06/01/2016 12:49 PM AEDT

Puerto Rico is on course to default on some of its debts on Monday, deepening a crisis that has been escalating steadily for months.

But the seemingly arcane dispute over the island's public finances masks a struggle for wealth and power in which the peculiarities of Puerto Rico’s political status and Wall Street greed play a leading role. 

Puerto Rico has $70 billion in total debt that its government says it cannot pay. No matter who wins, the vast majority of the 3.5 million U.S. citizens who call the island home aren't likely to see relief any time soon. 

Here are seven key facts to understand the debt crisis of a place most Americans know only as a vacation destination:

1. Puerto Rico is defaulting on a very small portion of its debt.

Puerto Rico Gov. Alejandro Garcia Padilla has said the island will not make a $35.9 million payment to its Infrastructure Finance Authority and another $1.4 million payment it owes its Public Finance Corp. That is a small fraction of the $1 billion in debts that comes due on Jan. 4, including a $328.7 million installment of general obligation debt, which the island’s constitution requires it to prioritize paying above all others debts. Puerto Rico already defaulted on payments owed to the Public Finance Corp. in August.

Still, the government has had to resort to extreme measures to make the payments on which it is not defaulting. Garcia Padilla told Reuters that the government had to take $163 million in revenues from other agencies in order to meet its Jan. 4 obligations, including the island’s highway, convention center and busing authorities.

Puerto Rican news outlet El Vocero also reported on rumors that the government will use money from the public employee pension fund to meet its Jan. 4 payments. The pension administrator said it has been selling assets, but only uses the proceeds to fund retirement benefits.

Pablo Martinez Monsivais/ASSOCIATED PRESS
Puerto Rico Gov. Alejandro Javier Garcia Padilla testifies on Capitol Hill in Washington, Dec. 1, 2015.

2. Puerto Ricans have already suffered tremendously to meet their obligations.

Among the government's tactics to save money is to postpone income tax refunds for an unknown number of Puerto Ricans.

José Javier Colon, a professor of political science at the University of Puerto Rico, is one of them: he has yet to receive a refund of $2,000 that is owed him, he said.

“The situation is very dire,” Colon said. “For me it is difficult to understand that people are questioning how severe the financial crisis is.”

For me it is difficult to understand that people are questioning how severe the financial crisis is. José Javier Colon, University of Puerto Rico

While Puerto Rico may technically be able to make its payments, as David Dayen notes in The American Prospect, it cannot do so without destroying its already-depressed economy.

Puerto Rico is trapped in a vicious cycle where the very austerity measures it has taken to meet short-term obligations to creditors -- such as laying off 30,000 public sector workers and increasing its sales tax from 7 percent to 11.5 percent -- have devastated its economy, depleting revenue sources and requiring even more drastic steps just to keep up with payments. One-third of the money coming into Puerto Rico’s coffers annually now goes toward paying creditors. 

The island’s economy has shrunk 10 percent since 2006 and it now has a poverty rate of 45 percent. The departure of 300,000 Puerto Ricans for the mainland United States in that time -- including 84,000 people in 2014 alone -- means that the burden of debt repayments will fall on an even smaller, poorer pool of island residents.

The government's latest move could be a play for time, posits Charles Venator, an assistant professor at the University of Connecticut who specializes in Puerto Rican politics. 

Puerto Rico’s Infrastructure Finance Authority and Public Finance Corp, the two entities the government will miss repaying on Jan. 4, will likely challenge the government in court. That means it could take a year before a court forces the government to pay up, Venator estimates.

That will give Garcia Padilla extra time to pressure Congress to grant the island bankruptcy powers, as he did Tuesday.

Joe Raedle/Getty Images
A ship passes past part of the wall that makes up La Fortaleza in Old San Juan, the original capital city of San Juan, Puerto Rico.

3. Puerto Rico cannot declare bankruptcy without Congress' permission -- and Congress has not been forthcoming. 

Normally, when a U.S. government, corporation or individual can no longer afford to pay back its lenders in full, it has the right to declare bankruptcy. In bankruptcy proceedings, a judge or arbitrator forges a compromise between the parties that typically forces creditors to take a loss, enabling the borrower to recover. The city of Detroit, for example, sought bankruptcy protection in July 2013, allowing it to cut 74 percent of its unsecured debt.

As a commonwealth of the United States, Puerto Rico cannot declare bankruptcy or otherwise restructure its debt without congressional approval. A Democratic-backed proposal to grant the island bankruptcy authority over some of its debts did not make it into the omnibus spending bill that Congress passed Dec. 18

Puerto Rico has tried to restructure its debt to public corporations -- a lower-priority category of debt than the constitutionally protected class of “general obligations” -- using a local bankruptcy law. But a federal court, siding with creditors who challenged the provision, ruled that federal laws barred the island from restructuring that debt. The Supreme Court will hear Puerto Rico’s challenge of the lower court ruling early this year and likely make a ruling by the end of June.

Christopher Gregory/Getty Images
The Puerto Rico Electric Power Authority's Palo Seco power plant stands in San Juan, Puerto Rico. The government is fighting to restructure debts it owes the company's investors.

The Obama administration seemingly dealt Puerto Rico a setback in its fight for financial independence last week when it argued in a brief for a separate case that the island is a territory that lacks virtually any standing as a sovereign entity -- and will continue to do so unless it achieves statehood or independence.

But Venator speculates that the maneuver may be designed to place the onus squarely on Congress by effectively saying the island is the sole responsibility of the U.S.

That would certainly be consistent with an approach recently outlined by Antonio Weiss, the Treasury Department official overseeing the administration’s response to the crisis. “Resolving Puerto Rico’s crisis requires congressional action,” Weiss said in a Dec. 9 speech at the Peterson Institute.

It is not likely that a resolution developed by a Republican-controlled Congress will be one that Puerto Rico’s Democratic-controlled government or suffering population find favorable.

Congressional Republicans have been less eager than Democrats to help Puerto Rico, arguing that the island must reduce social program spending and enact other fiscal reforms first.

House Speaker Paul Ryan (R-Wis.) has assured House Minority Leader Nancy Pelosi (D-Calif.) that the House will take action to aid the island by the spring, though it is unclear if that would include debt restructuring.

Peter Foley/Getty Images
Protesters demonstrate at the Puerto Rican debt talks outside Citibank Inc. headquarters on Park Avenue in New York City, on July 13, 2015.

4. Wall Street "vultures" are making a killing off the island.

Puerto Rico's terms of repayment are particularly onerous because so much of its debt is now controlled by big U.S. hedge funds.

In the last year, as Puerto Rico’s spiraling debt effectively prevented it from borrowing on ordinary credit markets, creditors began selling off Puerto Rican debt, as David Dayen reported in The American Prospect. A select group of big investors, most of them hedge funds, stepped in to buy the debt for a mere fraction of its original value.

These hedge funds are known as “vultures” because of their attempts to squeeze a profit from a penniless debtor’s proverbial carcass. Vultures buy the debt of cash-strapped sovereign nations -- think Greece and Argentina -- at discounted rates from other investors, who have grown scared they will not be paid back. Then the vultures use every means at their disposal -- the courts, political lobbying, the media -- to ensure that they are paid back at the full-dollar value of the discounted debts they purchased, as well as interest. In Puerto Rico’s case, investors can buy Puerto Rican government bonds from other bondholders for as little as 30 cents on the dollar of their original value and enjoy income from interest rates that go as high as 11 percent.  

Hedge funds also gave Puerto Rico a much-needed cash infusion in 2014, buying $3.5 billion in general obligation bonds that no one else was willing to buy.

It was a good deal for the investors: Puerto Rico’s bonds are tax exempt in all 50 states and the interest rate was 8.7 percent, amounting to what The New York Times estimates was “in effect, a 20 percent return.” What is more, Puerto Rico is constitutionally bound to prioritize payment of the general obligation bonds above all else.

Andrew Harrer/Getty Images
Sen. Marco Rubio (R-Fla.), a presidential candidate, initially supported a Senate bill granting Puerto Rico bankruptcy authority but later reneged.

5. Other hedge funds have fought to prevent Puerto Rico from gaining bankruptcy powers.

There are competing interests at play in the web of investors in Puerto Rican debt. Some of the vulture hedge funds, like those that own the higher-priority general obligation bonds, are supportive of attempts to force investors in Puerto Rico’s public corporations to accept losses. 

At the same time, other hedge funds, which own debt from Puerto Rico’s public corporations and other entities that would be affected by restructuring, have helped thwart the island’s attempts to persuade Congress to grant it bankruptcy power. 

Prior to the bankruptcy provision House Democrats tried to get into the omnibus bill, Sen. Richard Blumenthal (D-Conn.) was working closely with Sen. Marco Rubio (R-Fla.) on a similar bill granting Puerto Rico powers to declare Chapter 9 bankruptcy on some of its debts and give towns and public corporations bankruptcy powers as well.

But a group of hedge funds that includes D.E. Shaw -- a firm headed by top Hillary Clinton donor David Shaw -- played a key role in defeating the bipartisan effort with a multi-front lobbying offensive, as The New York Times reported at length. Blue Mountain, another hedge fund in the group, launched a sophisticated astroturf campaign casting the bill, which would cost taxpayers nothing, as a “bailout” that would harm ordinary seniors whose retirement plans rely on returns from Puerto Rican bonds.

Rubio withdrew his support under pressure, contributing to the bill’s ultimate collapse.

Puerto Rico has little room to take advantage of the apparent divisions between vulture hedge funds and those that have invested in its public corporations. Whether it faces endless legal battles against Wall Street lawyers over the terms of its exorbitant payments to the vulture hedge funds or voluntary negotiations with public corporation bondholders without being able to leverage the threat of bankruptcy, odds are there is a lot more financial pain in the island’s future.

Boston Globe/Getty Images
John Paulson, a billionaire hedge fund manager, is one of the deep-pocketed investors who has moved to Puerto Rico to take advantage of tax exemptions.

6. Puerto Rico is already a tax shelter for Wall Street billionaires.

Meanwhile, Wall Street is encouraging the island to enact more austerity to come up with the money needed to pay its debts.

A July report commissioned by hedge funds invested in Puerto Rican debt breaks new ground on the subject. It calls for the commonwealth to roll back labor protections, privatize public assets, lay off more public employees and raise sales taxes.

Puerto Rico’s previous governor, Republican Luis Fortuño, enacted several tax incentives in 2012 aimed at attracting foreign investors in hopes of boosting the island's finances. The main one was Act 22, a law exempting all of an individual’s investment income from income taxes once the person became a permanent resident of the island.

To critics, the calls for belt-tightening and higher taxes are hypocritical. In the wake of the new laws, many hedge fund executives have themselves moved to the island and bought property there as a tax avoidance scheme.

Hedge funds have a vested financial interest in promoting regressive tax regimes and lax regulation in order to maximize profits on their new investments in Puerto Rico. Those policies, by definition, may not be in “the best long-term interest of Puerto Rico,” as Matt Fabian of the research firm Municipal Market Analytics told The Huffington Post in July.

Christopher Gregory/Getty Images
The La Perla shanty town sits just a few steps from the upscale neighborhoods of Condado and Old San Juan on Nov. 12, 2013, in San Juan, Puerto Rico.

7. Wall Street and Congress share blame for Puerto Rico's accumulation of debt in the first place.

To hear some commentators tell it, Puerto Rico is in a mess entirely of its own making, and any attempt to provide it relief will only encourage the island’s bad behavior.

There is some truth in their argument. Successive Puerto Rican governments decided to issue more and more debt to cover costs, rather than make fiscal adjustments, when the island’s economy began generating less revenue than it had in the past. Puerto Rico’s debt increased every year since 2000, a report commissioned by the current government has found.

The island’s utility monopolies are notoriously inefficient. The state-owned power company relies on expensive and dirty fossil fuel imports to generate electricity for the island and is not transparent about the high rates it charges customers.

The World Bank ranked the island 57th in the world in terms of ease of doing business, just below Mongolia and above Costa Rica. (The United States is ranked seventh.)

Creditors who bought those bonds knew that there was an increasing gap between the economic activity of Puerto Rico and its debts. José Javier Colon, University of Puerto Rico

But all of that ignores two essential factors underlying Puerto Rico’s debt crisis.

Puerto Rico ramped up its debt accumulation in response to an economic calamity Congress largely created. From 1976 to 1996, Puerto Rico’s economy grew steadily thanks largely to Section 936 of the U.S. tax code, which exempted U.S. manufacturers on the island from taxes. In 1996, the Clinton administration and Congress passed a 10-year phase-out of the exemption, but as The American Prospect noted, “Congress did not replace Section 936 with an economic development plan for Puerto Rico to offset the impact.”

Manufacturers left Puerto Rico in droves as the exemption faded away and the island’s economy has never really recovered.

Another odd rule related to Puerto Rico’s reliance on the U.S. also hinders the island's economic potential. The Jones Act prohibits foreign-flagged ships from carrying cargo from one U.S. port to another. As a result, foreign ships with goods destined for the mainland U.S. cannot stop at Puerto Rico first -- or vice versa -- without transferring the cargo onto a U.S. ship.

The law is blamed for the high price of imported consumer goods in Puerto Rico.

In addition, U.S.-based investors actively participated in, and even encouraged, Puerto Rico’s debt binge. Puerto Rico’s municipal bonds, which are uniquely exempt from local, state and federal taxes in all 50 states, provided returns that were too hard to pass up. 

It is an opportunity to deal with a politically and economically bankrupt territorial system created by Congress. Charles Venator, University of Connecticut

Investors often bought the bonds despite their inherent risks, said Colon, of the University of Puerto Rico.

“Creditors who bought those bonds knew that there was an increasing gap between the economic activity of Puerto Rico and its debts,” Colon said. “The financial sector made lots of money off those bond sales.”

The sector's role in creating the crisis does not eliminate the need for political and fiscal reforms in Puerto Rico, Colon insisted.

But it does undermine arguments against granting Puerto Rico authority to declare bankruptcy over at least some of its debts, which Colon said is “essential.”

Venator sees a long-overdue resolution of Puerto Rico’s ill-defined political status as a possible silver lining of the debt crisis.

“It is an opportunity to deal with a politically and economically bankrupt territorial system created by Congress,” he said.

CORRECTION: An earlier version of this story incorrectly suggested that U.S.-based labor union pension funds were significant purchasers of Puerto Rican municipal bonds.

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