Puerto Rico's ticking time bomb

With all eyes on Greece it would seem another crisis relating to unpayable debt is brewing in the Caribbean. The governor of Puerto Rico, Alejandro García Padilla, has warned that the island is unable to pay its debts of $72 billion.

Puerto Rico has managed to rack up an astounding level of debt relative to the size of its economy. Moody’s estimates the small U.S. territory to have bond debts fifteen times greater than the median bond debt of the 50 U.S. states.

Padilla has warned that by 2025 the island could have bond debt of up to $40,000 for every man, woman and child – in a territory with high unemployment and where the average annual wage is less than $20,000.

The debt was amassed by offering too-good-to-be-true terms to U.S. investors wishing to avoid paying high taxes at home. Interest paid on Puerto Rico’s bonds are tax exempt in the U.S.

A complicated set of arrangements lulled investors into a false sense of security with regards to Puerto Rican bonds. For a start, the constitution “contains an unusual clause that requires general-obligation bonds to be paid ahead of virtually any other government expense,” according to the New York Times.The government then promised specific revenue streams to different groups of bondholders.

The 2008 crisis hurt the economy badly and the government continued to promise more and more revenue streams in order to issue more and more bonds, the funds from which were used to finance current expenditure. Now there is simply not enough cash to finance debt and public services.

The governor did not specifically say that debts would be restructured. He did, however, say that he was “guaranteeing our citizens essential services and our pensioners a just income.”

Now, bondholders are at risk as are the funds which hold Puerto Rican bonds and, more importantly, those who insure them in the derivatives market.

Dave Kranzler, from Investment Research Dynamics has warned that there are signs that the Puerto Rico situation may not remain a local crisis for much longer.

He points out that share prices of MBIA, the bond insurers have been plummeting. MBIA are valued at $3.9 billion whereas their exposure to Puerto Rican debt is around $4.5 billion. Kranzler reckons their exposure could even be multiples of that figure. A default could wipe them out.

He also points out that the firm’s largest shareholders are Warburg Pincus, the firm to which Timothy Geithner went after his stint as Treasury Secretary, when he helped paper over the chasms opening up in the financial system.

Geithner is, therefore, better placed than most to estimate the risks posed by various bond issuers. If it is Warburg Pincus who are shedding their MBIA stock it is likely that more trouble is brewing in Puerto Rico.

About the Author
Stephen Flood is a director of Ireland-based GoldCore.