Imagine picking up a pebble and tossing it into the ocean.
Did it cause a tidal wave? Probably not.
Did it do absolutely nothing at all? More likely.
On August 3rd, Puerto Rico defaulted on a $58 million bond payment. It offered, instead, a $628,000 payment on the interest owed. You following the whole pebble/tidal wave thing?
For the first time in its history, the island territory will be unable to meet its debt obligations. Given the size of the debt, a staggering $70 billion, one may wonder…how the hell did we get here?
Wait, let’s get some context here. Is $70 billion really that big of a number?
A Little Context
Two U.S. states have debts outstanding quite similar to Puerto Rico’s: New York and California.
California has debt outstanding of $117 billion. That’s pretty huge, but they also have a population of 38 million. New York has outstanding debts of $55 billion, but the northeastern state is also 20 million people strong. Puerto Rico is a tiny island with 3.5 million people – and they are losing people by the day thanks to migrant outflow.
When you consider these numbers in the form of debt per capita (per person), it looks…even worse. California’s citizens are carrying a debt load of around $3,000 per head, New York’s stands at $2,750. Each person in Puerto Rico holds $20,000 worth of debt.
How did this tiny, unincorporated U.S. territory of 3.5 million people run up such a high bill?
It definitely didn’t happen overnight. In fact – Puerto Rico’s debt troubles are actually the culmination of a near decade-long recession. Falling investment, combined with a wicked housing bubble, population shrinkage and a miserable economic climate…yup, it didn’t happen overnight.
A Little History
Let’s go back a little bit further. In the 70’s, the U.S. wanted to encourage big corporations who wanted to move operations offshore to move to Puerto Rico instead. To do so, they granted huge tax breaks to companies. These tax breaks ended in 2006 and as a result, many companies moved their business elsewhere (i.e. The Cayman Islands). All this money was just flowing out of Puerto Rico. No bueno.
Investment on the island has been falling since 2004, which – when you add in a real estate crash more acute than the one on the mainland United States – doesn’t exactly inspire confidence in what’s to come.
Real estate is just not moving in Puerto Rico. Over the last few years, developers and financial institutions have been trying to entice buyers into new homes…to no avail. In 2004, a total of 13,419 new homes were sold. In 2008, that number stood at 9,826. By 2009, the number of residential property sales declined 51% with only 5,023 units sold. The fish just aren’t biting.
Local banks were able to sell off most of the bad home loans by 2014 – but at the same time, no one was buying. Which is partly the result of a dismal economic climate.
The economy is in a deep recession, spanning nearly a decade. This pushed the unemployment rate above 16% between 2010 and 2012. These conditions set the stage for an exodus, with many Puerto Ricans moving to the U.S. mainland in search of greener pastures. Puerto Rico’s population grew pretty steadily following World War II, reaching a peak of about 3.8 million in 2004, but has been declining since. The 2014 population estimate: 3.548 million.
Migration has completely changed the demographics of Puerto Ricans on the island. Nearly a third of the Puerto-Rican born population lives on the U.S. mainland.
Okay, let’s recap. The housing market crashed. The island territory was already experiencing tough times. It forced many thousands of Puerto Ricans onto the U.S. mainland in search of better jobs and prospects. This exodus didn’t help the Puerto Rican economy. Instead of finding a way to revitalize the economy, or explore new policy, the government decided to borrow money.
And people were happy to lend them the money. Middle class Americans investing in retirement funds found their money being funnelled into Puerto Rico. Why Puerto Rico?
A Little Tax Advantage
Well, it just so happens that Puerto Rican bonds have some unusual tax advantages. They are ‘triple-tax exempt’ – which means you don’t have to pay 1) federal, 2) state or 3) local taxes on them. Municipal bonds are usually triple-tax exempt only if you purchase them in the city that you live in, so demand for Puerto Rican bonds was high.
Picture the scenario. You are a government official. The economy is crap. The housing market is crap. The way you decide to go about funding everything is to borrow a ton of money. People want to lend you that money because you’re offering generous tax-exemptions.
And it’s not like they did much with all that easy money. Rather than invest for the future, Puerto Rico instead used the windfall to finance a welfare state that they couldn’t afford. The worst part about all of this is that because Puerto Rico is not a U.S. state, (it’s an unincorporated territory, remember?) it declare bankruptcy (like Detroit did).
Dig a little deeper and find that Puerto Rico’s sub-state entities (towns, cities and public corporations) can’t declare bankruptcy either. The government passed a law allowing public companies to declare bankruptcy in 2014…but that was overturned by U.S. federal law.
So, what happens next? It’s kind of unclear. Puerto Rico’s debt troubles have come at a time when they seriously need to focus on the economy. The best one can hope for is that the territory and its creditors work together. If they could set up some sort of debt forgiveness/reasonable payment plan so that the island commonwealth could have some breathing room and time to reassess…that’d be cool.
But yeah, overall: no bueno.
To learn more, head over to Wall Street Survivor :)