Puerto Rico’s Debt Crisis in Seven Questions

Congress begins considering legislation Wednesday to address the U.S. territory’s inability to pay its debts

A demonstrator protests the Federal Reserve's inaction on Puerto Rico’s debt crisis outside International House last week in New York. Congress debates legislation this week. PHOTO: KATHY WILLENS/ASSOCIATED PRESS

A demonstrator protests the Federal Reserve’s inaction on Puerto Rico’s debt crisis outside International House last week in New York. Congress debates legislation this week. PHOTO: KATHY WILLENS/ASSOCIATED PRESS

The Wall Street Journal – Congress begins considering legislation Wednesday that addresses Puerto Rico’s debt crisis. Here’s a look at seven frequently asked questions:

How did Puerto Rico end up with so much debt?

The island’s economy has been in recession since 2006, and Puerto Rico’s government borrowed aggressively to balance its budget. It has around $70 billion in debt, up from $24 billion in 2000. To skirt debt-sustainability requirements, it devised new bond issues with competing security pledges.

Today, many creditors lament the island’s deep political dysfunction that they say has failed to properly collect taxes or rein in a bloated public sector. But these problems are not new and some investors were willing to tolerate them for years because they believed that the island’s economic problems would eventually turn around. Also, unlike other municipal bonds, Puerto Rican debt is exempt from local, state and federal taxes, which made them an attractive investment during an era of low yields.

Is there a humanitarian crisis on the island?

The island’s public services are, for the most part, still functioning. Creditors say that concerns about a humanitarian crisis are being exaggerated by local officials and the Obama administration to scare Congress into providing debt relief that isn’t necessary.

Still, there are looming threats. The Centers for Disease Control and Prevention estimates that more than one-fifth of the population could become infected with the mosquito-borne Zika virus this year, testing the island’s public-health infrastructure.

Other analysts say the island’s debt burden will ultimately make it impossible for the island to grow its economy. One telltale sign of economic crisis: The island’s population is falling dramatically as Puerto Ricans, who are U.S. citizens, move to the mainland. The population decline easily outstrips that of the most distressed Rustbelt counties.

“It’s a $99 ticket from San Juan to Orlando,” said John Ceffalio, a municipal-credit analyst at AllianceBernstein. “Puerto Ricans are voting with their feet.”

Why is Congress getting involved?

Normally, a distressed municipality could reorganize its debts through the U.S. bankruptcy code, which is what Detroit did in 2013. But this option is only available to municipalities in U.S. states, not to those in federal territories like Puerto Rico.

The Obama administration also says a federal response is needed because of the complexity of the island’s debt structures. Competing claims from different investors could expose the island to protracted inter-creditor legal battles that some analysts say could take years, maybe even a decade, to resolve.

What is Congress proposing to do?

The House Committee on Natural Resources, which has jurisdiction over U.S. territories, has advanced a bill that would create a financial oversight authority with the power to approve budgets submitted by the governor and passed by the local legislature. The oversight board would also have the power to initiate debt restructuring under a court-supervised process. Debt restructuring wouldn’t cost taxpayers anything.

Republicans have insisted on stiffer financial controls for the island, while Democrats and the Obama administration have said any bill must allow for the island to restructure its debt. A financial oversight board is extremely unpopular with Puerto Rico’s elected officials, and many creditors are very opposed to allowing a federal judge to entertain debt restructuring.

Some people have called this a bailout. Why?

During the 2008 financial crisis, bankruptcy was often viewed as the opposite of a bailout. But bondholders have characterized debt restructuring as a bailout because they say it would retroactively change rules governing their investments, potentially undermining confidence in the broader municipal bond market.

Advocates of the legislation say those investments will lose money anyway if Puerto Rico can’t pay its debts. Given how well-advertised Puerto Rico’s problems have been to investors, concerns that changes in how those bonds are treated will ripple throughout the broader municipal market are “completely false,” said John Miller, co-head of fixed income at Nuveen Asset Management LLC.

How does Puerto Rico’s debt picture compare with U.S. states?

In July 2014, debt service accounted for 27% of Puerto Rico’s government revenues, more than double the highest share of any U.S. state, according to Moody’s Investors Service. Some critics say these numbers overstate Puerto Rico’s debt because the island’s residents don’t pay federal income tax and that any state comparisons should incorporate the federal tax burden.

Analysts at Nuveen disputed this line of argument in a February report, noting important differences between municipal debt and sovereign debt, which isn’t traditionally amortized with regular principal payments. “Any attempt to lump total federal government debt outstanding into state debt profiles is an attempt to inflate state indebtedness to give Puerto Rico’s debt the veneer of affordability,” the analysts wrote.

What happens if Congress can’t agree on a solution?

Federal courts struck down last year a local law that would have created a bankruptcy-like path for the island’s public corporations. The U.S. Supreme Court heard arguments in the appeal last month and should rule by June. If the local restructuring law is reinstated, Puerto Rico could have more leverage with its creditors.

Many analysts expect the government to default on some portion of payments totaling more than $2 billion due in May and July, triggering lawsuits against the government. Puerto Rico’s legislature approved and the governor last week signed a law that would allow the government to stop making debt payments.

Calls could mount for the U.S. Treasury to backstop loans to the island. This would represent an actual bailout of the island and, depending on how such guarantees were structured, of its creditors.

“If nothing happens, there will be a total default in Puerto Rico, and I can assure you, there will be a bailout at that stage of the game,” Rep. Rob Bishop (R., Utah), the chairman of the natural resources committee, said in a radio interview with KSL-FM in Salt Lake City last week. “Somebody will have to step up when the government no longer has money to buy fuel for their cop cars or for their ambulances.”

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