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June 30, 2015

Puerto Rico: The American Greece?

On Monday, Puerto Rico’s government released a report that gave the municipal bond market the willies.

Written by former World Bank and IMF economists, it vivisects Puerto Rico’s finances, lays out the basic fact that the nearly $73 billion in bonds that the US commonwealth has outstanding, amounting to nearly 70% of its GDP, are of dubious value, and offers a debt restructuring strategy.

The report is decorated with financial doom and gloom: Outmigration has caused the population to drop nearly 8% since 2006 to 3.5 million today, even while the debt kept ballooning. It contained this choice passage:
The single most telling statistic in Puerto Rico is that only 40% of the adult population – versus 63% on the US mainland – is employed or looking for work; the rest are economically idle or working in the grey economy. In an economy with an abundance of unskilled labor, the reasons boil down to two. 
– Employers are disinclined to hire workers because (a) the US federal minimum wage is very high relative to the local average (full-time employment at the minimum wage is equivalent to 77% of per capita income, versus 28% on the mainland) and a more binding constraint on employment (28% of hourly workers in Puerto Rico earn $8.50 or less versus only 3% on the mainland); and (b) local regulations pertaining to overtime, paid vacation, and dismissal are costly and more onerous than on the US mainland.  
– Workers are disinclined to take up jobs because the welfare system provides generous benefits that often exceed what minimum wage employment yields; one estimate shows that a household of three eligible for food stamps, AFDC, Medicaid and utilities subsidies could receive $1,743 per month – as compared to a minimum wage earner’s take-home earnings of $1,159. The result of all of the above is massive underutilization of labor, foregone output, and waning competitiveness.

To fix this situation, bondholders are now asked to step up to the plate.

Governor Alejandro García Padilla told the New York Times that “the debt is not payable,” that there “is no other option,” that this “is not politics” but “math.” His administration is trying not to default, he said. “But we have to make the economy grow. If not, we will be in a death spiral.”

Expected Default Rate Has Been Worse in Puerto Rico Than the Ukraine 

Chart Source: Fidelity Investment, Aug. 2014 (Added by EconMatters)

These are not the soothing words the bond market has been yearning for.

Puerto Rico is unlikely to make the debt payment due Wednesday, and if it can’t raise new money by selling additional debt, though it already can’t service its existing debt, the government said it might have to shut down by September, which would entail furloughs and other cash-preserving measures. Some analysts figured it could run out of money as early as July.

Ratings agency Fitch, upon hearing the good news on Monday, cut Puerto Rico’s general obligation bonds to CC, deep into junk territory, and kept it on Rating Watch negative, with further downgrades looming, to reflect, as Fitch said, its “belief that default of some kind appears probable….”

Beyond GOs – which Puerto Rico’s constitution says must be paid before government employees get paid – there are billions of dollars in bonds that public utilities and other entities have sold. On top of its bonds, it faces $37 billion in pension obligations. But unlike Detroit, the largest municipal bankruptcy in US history, Puerto Rico cannot use a bankruptcy process to shed its debts. It can only negotiate with creditors to restructure them.

Puerto Rico’s $73 billion in bonds are a lot of paper to spread around. Investors were lured with tax advantages, now obviated by events. If you own municipal bond mutual funds, chances are you own Puerto Rico bonds, though hedge funds have been buying them too. And those bonds just plunged on Monday.

But beyond bond funds, someone else is getting hit. Remember the bond insurers that were being shredded by the housing bust because they’d insured mortgage backed securities? They got hit again insuring junk.

Shares of bond insurers Ambac Financial dropped 11.9% on Monday. They’re down 26% from their 52-week high in January, and 43% from their lofty levels in February 2014.

Shares of Assured Guaranty fell 13.3% on Monday. After zigzagging up to their post-financial-crisis high just a week ago, they have plunged 19.4% in four trading days.

And MBIA, which insures about one-fifth of Puerto Rico’s municipal bonds, plunged 23.4% on Monday. MBIA was a highflyer before the Financial Crisis, trading at over $70 a share in late 2006, before it all collapsed. Now, shares have crashed 33% over the past 5 trading days to $6.37 a share.

Analysts seemed surprised.

“Our buy ratings on Assured Guaranty and MBIA were predicated on our belief that the governor was going to do everything in his power to continue to repay [Puerto Rico’s] debt,” Mark Palmer, an analyst at the brokerage firm BTIG, told the Wall Street Journal after he belatedly downgraded Assured Guaranty and MBIA to neutral from buy, and maintained his neutral rating on Ambac.

Turns out, today everything changed. “A lot of the thinking about how Puerto Rico could dig itself out of the hole is no longer applicable,” he said.

Barclays could not rule out “scenarios in which multiple Puerto Rico issuers restructure their debt, which could cause significant loss” for MBIA and Ambac. Net charges of $750 million or more would degrade the insurers’ capital bases, which could lead to downgrades and diminished abilities to write new business, Barclays’ analysts told the Wall Street Journal, adding, “The current market value of uninsured Puerto Rico bonds suggests losses of this magnitude are at least possible.”

But these bonds are not the only municipal bonds Ambac, Assured Guaranty, and MBIA have insured. More hits, with echoes of the mortgage crisis, are waiting to happen.

Puerto Rico is the largest hiccup so far in the municipal bond market, preceded by the bankruptcies in recent years of Detroit, MI; Vallejo, San Bernardino, Stockton, and Mammoth Lakes, CA; Jefferson County, AL. Harrisburg, PA; Central Falls, RI; and Boise County, ID. Others, crushed by debts and pension obligations, are limping in that direction too.

When Meredith Whitney, who’d ridden to fame in 2007 on a prescient report about Citi, predicted in December 2010 that there would be “a spate of municipal-bond defaults,” namely, “50 to 100 sizable defaults, or more,” amounting to “hundreds of billions of dollars’ worth of defaults,” she only got the timing wrong. These things get kicked down the road for years until there’s no more road left. And then a default happens “suddenly.”

Courtesy Wolf Richter, Wolf Street

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