U.S. Territory Declares Bankruptcy

If this could happen to an American territory, could it happen to an American state?

U.S. territory Puerto Rico is bankrupt – could it happen to the states?

Experts say it will.

In 1999, the U.S. territory of Puerto Rico had an investment-grade credit rating and roughly $16 billion in bond debt.

But unlike U.S. states, Puerto Rico was not required to have a balanced budget. The island’s 1952 constitution also enabled Puerto Rico to issue debt to fund many activities, including day-to-day operations such as salaries, education, and health care.

Predictably, borrowing soared.

By 2006, Puerto Rico already owed $43.5 billion in outstanding bonds. To make matters worse, a long recession started in 2006 and continues to this day. With diminished revenue, Puerto Rico had to keep borrowing to make ends meet.

Fast forward to 2017, and the debt numbers are astronomical.

Today the island territory has $74 billion in bond debt, and its credit rating is junk. It also has $49 billion in unfunded pension obligations. These numbers add up to a huge combined mountain of debt – $123 billion dollars worth.

Where did all this money go?

It’s hard to say, exactly. Puerto Rico hasn’t filed audited financial statements since the 2014 fiscal year.

But we do know of a few fiscal boondoggles.

The Puerto Rico infrastructure agency, PRIFA, issued $470 million in bonds backed by rum taxes to help finance a 13,000-seat arena, an aquatic complex, and a 10,500-seat stadium.

But in 2016, average attendance at home games of the Indios de Mayaguez baseball team played at the stadium was only 1,327 people, leaving an almost-empty stadium.

San Juan’s train, the Tren Urbano, has cost $2.25 billion so far. It is about $1 billion over budget, badly under-utilized, and losing money on operations. The stations are nearly empty.

Puerto Rico’s bonds did pay for some long-term investments such as schools, hospitals, public parks, government buildings, and infrastructure. That’s what bonds are normally used for.

But bonds also paid for everyday expenses such as salaries, budget deficits, and funding public pensions. Long after that money was spent, the bonds and their interest still needed to be paid.

With such huge debt and limited prospects, who would buy those bonds and lend them even more money to squander? Wall Street, for one.

Hedge fund investors loaded up on Puerto Rico bonds, and currently hold about one-third of Puerto Rico’s debt. Distressed debt speculators were betting that Puerto Rico would be able to cut government spending, and push out high-yield bond maturities to delay principal repayment.

They started buying this risky bond debt in 2013, after Puerto Rico’s long recession and associated budget shortfalls caused other investors to flee.

It was an attractive opportunity in distressed US municipal bonds. The large outstanding debt, high yields near 8%, and discounted value made it easy to buy large positions.

After all, municipal bonds seldom default. The Puerto Rico bonds were triple tax-free, exempt from local, state and federal taxes in America. The bonds were also protected by Puerto Rico’s constitution… or were they?

The answer was not long in coming.

USA bankruptcy?

The Puerto Rico government began defaulting on bonds in 2015. Eventually, Puerto Rico filed for the biggest municipal reorganization – essentially bankruptcy – in American history on May 3, 2017. With too much debt and too little income, it had no choice. With an uncertain future, Puerto Rico bond values plummeted.

Puerto Rico is legally barred from using federal bankruptcy code’s Chapter 9, usually used by insolvent local governments. Instead, they used a federal law for insolvent territories called Promesa. Enacted in 2016, Promesa contains certain Chapter 9 bankruptcy provisions that allowed Puerto Rico to petition for relief and negotiate with creditors.

If this could happen to an American territory, could it happen to an American state? The answer may surprise you.

In America, individuals and businesses can declare bankruptcy. Many cities, school districts, and other local governments can file bankruptcy where not prohibited by state law. But current federal law does not even address the ability for states to declare bankruptcy… yet.

If the law did change and a state tried to file bankruptcy, the contracts clause and the 10th amendment of the U.S. constitution stand in the way. History also indicates there is almost zero chance of the federal government bailing out an indebted state government.

If states can’t go bankrupt and can’t count on a federal bailout, what’s going to happen to those states with huge unfunded but looming liabilities such as state and local pension funds?

At some point, the money is going to run out. So far, Connecticut, Illinois, Kentucky, New Jersey and Massachusetts are considered the states most likely to fail.

If so many states are barely scraping by while interest rates are low, then when rates increase, so will state problems. To allow them to get back on track financially, Chapter 9 or Promesa may need to be revised to include states.  If that does happen, some bonds will lose value very quickly as the states negotiate with creditors.  Caveat emptor – invest carefully.

Leave your vote

5 points
Upvote Downvote

Total votes: 7

Upvotes: 6

Upvotes percentage: 85.714286%

Downvotes: 1

Downvotes percentage: 14.285714%

This post was created with our nice and easy submission form. Create your post!