MONEY Banks

Bank of America Is Paying Up for the Mortgage Mess, But Who Will Get the Money?

Affordable housing construction
Kiet Thai—Getty Images

The banks has agreed to provide billions of dollars in "consumer relief." Here's what that actually means.

Last week, Bank of America agreed to pay almost $17 billion dollars in a settlement with the Justice Department. The settlement is about what Bank of America (and Merrill Lynch and Countrywide, which BoA later acquired) disclosed to investors about mortgage-backed securities, not about how it treated homeowners. Nonetheless, a large portion of the settlement—$7 billion—will be used for consumer relief.

So who will actually see some of that money? Bank of America can pay off its new obligation in four ways:

Reducing the principal or modifying payments on some mortgages. Mortgage modification isn’t anything new—the government has had programs to encourage banks to do this for years, though they’ve been criticized as too little or too late. However, compared to past settlements, the BoA deal does break some ground by targeting the relief. For the first time, 50% of principal reductions will go to borrowers in the areas hardest hit by the housing crisis. The Office of Housing and Urban Development has published an interactive map of these areas here. The settlement also gives the bank incentives to prioritize FHA and VA loans.

Bank of America’s agreement with the government also provides more substantial aid than previous settlements in certain cases. For example, BoA is required to provide $2.15 billion in principal forgiveness, which consists of lowering underwater mortgages to 75% of the property’s long term value, and reducing the mortgage’s interest rate to 2%.

“Those borrowers who do get assistance through the settlement are getting pretty substantial assistance,” says Paul Leonard, founder of the Center for Responsible Lending.

In addition to principal reduction, BoA will receive credit toward the settlement amount by forgiving mortgage payments, allowing for delayed payments, or extinguishing some second liens and other debts.

Who actually gets this help, though, is up to BoA. “Bank of America still gets to make all the final calls,” Leonard explains. “Even if I’m a borrower in default in a hardest hit area, who would seem like natural candidate for assistance, there is no entitlement to me.” As for the timetable, the bank has until 2018 to provide this aid, although the agreement includes incentive to finish early. BoA suggests anyone in serious hardship call 877-488-7814 to see if they qualify for an existing program.

More low and moderate income lending. For low-income Americans, first time homebuyers, or those who lost their home in a short sale or foreclosure, it can be extremely difficult to get a loan—even with a good credit. This settlement offers BoA credit for giving mortgages to these groups, or those in hardest hit areas, as long as they have respectable FICO score.

Building affordable rental housing. It’s also hard to find cheap rental housing, and financing for such development is scarce. As part of BoA’s agreement with the Justice Department, the bank will provide $100 million in financing for construction, rehabilitation or preservation of affordable rental multi-family housing. Half of these units must be built in Critical Family Need Housing developments.

Getting rid of blight and preventing future foreclosures. One side effect of the housing crisis was the large number of abandoned or foreclosed homes plaguing neighborhoods across the nation. BoA will earn credit for demolishing abandoned homes, donating properties to land banks, non-profits, or local governments, and providing funds for legal aid organizations and housing counseling agencies. The bank will also receive credit for forgiving the principal of loans where foreclosure isn’t being pursued.

Housing advocates say they’ll be keeping an eye on how quickly BoA and other banks that have agreed to consumer relief act on these programs. One worry is that by going slowly they could end up paying off the settlements with modifications and lending they would have done anyway. “If the promised relief arrives, as written, then it will bring a measure of relief that is badly needed by a lot of communities out there,” acknowledges Kevin Whelan, national campaign director of Home Defenders League. “But compared to the damage these institutions caused, it’s not really a large amount of money.”

Related:
What Bank of America Did to Warrant a $17 Billion Penalty
How to Get a Mortgage When Your Credit is Bad
Behind on Your Mortgage? You May Be Eligible for Some Help

MONEY financial crisis

What Bank of America Did to Warrant a $17 Billion Penalty

A protester holds up a sign in front of the Bank of America as a coalition of organizations march to urge customers of big banks to switch to local credit unions in San Diego California November 2, 2011.
Mike Blake—Reuters

It's the biggest settlement ever between a corporation and the U.S. government. Here's what it reveals about how bankers inflated the housing bubble.

Bank of America has agreed to pay $16.65 billion dollars in penalties—the largest settlement ever between the U.S. government and a private corporation—for its role in the financial crisis. As Attorney General Eric Holder said Thursday morning, the payout will help “hold accountable those whose actions threatened the integrity of our financial markets and undermined the stability of our economy.”

So what did Bank of America actually do? As part of the settlement, the Justice Department has issued a 30-page “Statement of Facts,” signed by the bank, detailing the actions Bank of America is paying for today. The document includes events that took place at Merrill Lynch and Countrywide, which Bank of America later acquired. It’s full of e-mails and statements from employees and executives, which often make for infuriating, if sometimes grimly funny, reading.

Here’s what happened. In the years leading up to the financial crisis, Bank of America and Merrill Lynch sold various securities based on home loans. If the buyers paid their loan back, investors made money, but if too many defaulted, investors lost. To make sure investors knew what they were getting into, the two companies were required to report to investors on how safe these loans actually were.

The problem? Both BoA and Merrill, the statement says, knew with increasing certainty that many of their loans were troubled or at least likely to be risky, and didn’t fully disclose this.

At Merrill, one consultant in the company’s due diligence department complained in an email:

[h]ow much time do you want me to spend looking at these [loans] if [the co-head of Merrill Lynch’s RMBS business] is going to keep them regardless of issues? . . . Makes you wonder why we have due diligence performed other than making sure the loan closed.

The Merrill email pales next to the almost-cartoonish cynicism on display in some Countrywide emails. In addition to selling mortgage-backed securities, Countrywide was on the front lines giving mortgages to home buyers. Justice Department documents suggest that the company increasingly offered loans to almost anyone who walked in the door. What mattered was whether the loan could later be sold to someone else. Wrote one exec:

My impression since arriving here, is that the company’s standard for products and Guidelines has been: ‘If we can price it [for sale], then we will offer it.’

In an email from 2007, another executive reflected that:

[W]hen credit was easily salable… [the desk responsible for approving risky loans] was a way to take advantage of the ‘salability’ and do loans outside guidelines and not let our views of risk get in the way.

Because why should a mortgage company care about risk?

But what makes Countrywide special isn’t just that they gave out a lot of bad loans, it’s that they sold those bad loans to others while keeping the good ones for themselves. In a 2005 email, the Countrywide Financial Corporation (CFC)’s chairman—not named in the statement, but it was Angelo Mozilo—wrote that he was “increasingly concerned” about a certain adjustable rate loan. He feared that the average borrower was not “sufficiently sophisticated to truly understand the consequences” of their mortgage, making them increasingly likely to default. He wrote:

…the bank will be dealing with foreclosure in potentially a deflated real estate market. This would be both a financial and reputational catastrophe.

So what did Countrywide do about it? Sell the products on the secondary market, and keep only the mortgages given to more qualified buyers. According to the settlement document, Countrywide’s public releases “did not disclose that certain Pay-Option ARM loans included as collateral were loans that Countrywide Bank had elected not to hold for its own investment portfolio because they had risk characteristics that [Countrywide Financial Corporation] management had identified as inappropriate for [Countrywide Bank].”

In another email, this time from 2006, CFC chairman Mozilo explicitly spelled out this policy to the president of Countrywide Home Loans, writing:

important data that could portend serious problems with [Pay- Option ARMs]. Since over 70% have opted to make the lower payments it appears that it is just a matter of time that we will be faced with a substantial amount of resets and therefore much higher delinquencies. We must limit [CB’s retained investment in] this product to high ficos [credit scores] otherwise we could face both financial and regulatory consequences.

What do you know? Looks like those “financial and regulatory consequences” happened anyway.

TIME Money

Bank of America To Pay Record $16.65 Billion Fine

Bank Of America Reports Loss Due 6 Billion Dollar Legal Charge
Spencer Platt—Getty Images

$7 billion of it will go to consumers faced with financial hardship

Updated: 10:14 a.m.

The Justice Department announced Thursday that Bank of America will pay a record $16.65 billion fine to settle allegations that it knowingly sold toxic mortgages to investors.

The sum represents the largest settlement between the government and a private corporation in the United States’ history, coming at the end of a long controversy surrounding the bank’s role in the recent financial crisis. In issuing bad subprime loans, some observers say, the bank helped fuel a housing bubble that would ultimately burst in late 2007, devastating the national and global economy.

“We are here to announce a historic step forward in our ongoing effort to protect the American people from financial fraud – and to hold accountable those whose actions threatened the integrity of our financial markets and undermined the stability of our economy,” Attorney General Eric Holder said at a news conference announcing the settlement.

Since the end of the financial crisis, the bank has incurred more than $60 billion in losses and legal settlements. Of the latest settlement, $7 billion will go to consumers faced with financial hardship. In turn, the bank largely exonerates itself from further federal scrutiny.

However, not all is forgotten. The New York Times reports that federal prosecutors are preparing a new case against Angelo Mozilo, the former chairman and chief executive officer of Countrywide Financial, which Bank of America acquired in mid-2008. As the country’s largest lender of mortgages, Countrywide Financial purportedly played a large role in distributing toxic loans. Mozilo has already paid the Securities and Exchange Commission a record $67.5 million settlement.

MONEY Housing Market

The 5 Cities That Have Recovered Most—and Least—From the Recession

Some areas have rebounded nicely since the financial crisis. But many have not.

On Wednesday, the Department of Commerce announced the U.S. economy grew a healthy 4% in the second quarter of 2014. The good news aligns with other positive economic signals, like an increase in hiring, and suggests the nation as a whole might be on the road to recovery.

Unfortunately, this rosy picture hasn’t been shared equally across the United States. Some areas have recovered well, while others have struggled. A new report from personal finance social network WalletHub highlights which municipalities have made the most progress toward normalcy since the downturn, and the areas that still have a way to go. To compile the list, WalletHub analyzed 18 economic metrics for the 180 largest U.S. cities, including the inflow of college-educated workers, the rate of new business growth, unemployment rates, and home price appreciation.

Here are the results.

Most Recovered Cities

Klyde Warren Park, Dallas, Texas.
Home prices in Dallas have shot up since the crisis, bolstering the city’s economy. Trevor Kobrin—Dallas CVB

1. Laredo, Texas

Over the past seven years, this Southern Texas city’s median income has increased 5% while the population has surged 13%. State-wide bankruptcy is down, and new business growth is up.

2. Irving, Texas

Irving, sandwiched between Dallas and Fort Worth, earned high marks for rising median income (up 6% since 2007) and a decreasing ratio of part-time to full-time workers. The area has seen more college-educated workers moving in.

3. Fayetteville, North Carolina

More workers moved from part-time to full-time gigs in this city than any other place. Plus more college-educated workers are coming than going, helping the population spike over 14% since 2007.

4. Denver, Colorado

The Mile High City has seen a 12% jump in median income since the financial crisis. Most impressively, it’s one of the few areas to have seen home prices completely recover (and then some) from the housing crash.

5. Dallas, Texas

Dallas is still dealing with an increased ratio of part-time to full-time workers, but median income is up nearly 4% and home prices have appreciated a shocking 17% since the housing bubble burst.

Least Recovered Cities

Newark, New Jersey
Newark, New Jersey is still struggling to come back from the financial crisis. Flickr

1. San Bernardino, California

This Southern California city ranks as the farthest away from a full recovery. Both income and housing prices have dropped since 2007, with median income down 4%, and home prices down 43%. San Bernardino’s ratio of part-time to full-time jobs has also gone up nearly 14%.

2. Stockton, California

This Northern California inland area isn’t doing so well either. Incomes are down. Home prices have severely depreciated (down more than 43% from seven years ago), and the foreclosure rate is close to 18%.

3. Boise City, Indiana

Residents of Boise City have suffered an 8% drop in their median income since the crisis. Despite there being increasingly more full-time work opportunities, relative to part-time roles, new business growth remains far below its pre-recession level, down roughly 11%.

4. Newark, New Jersey

The median income remains down almost 5% in this urban area, adjacent to New York. Homes have been hit hard too. Housing prices are about 41% lower than they were in 2007.

5. Modesto, California

This town, which neighbors depressed Stockton, also hasn’t been able to break out of its post recession funk, likely because home prices remain down about 35%, and new business growth almost 9%.

MONEY Citigroup

Here’s Why Citigroup Is Shelling Out $7 Billion

It wasn't just investors who were hurt when banks turned lousy mortgages into toxic bonds

+ READ ARTICLE

You could be forgiven for not caring — or perhaps not even noticing — that Citigroup agreed yesterday to pony up $7 billion to settle a Justice department inquiry into its mortgage business. More than five years after the financial crisis, the legal process of holding banks accountable can feel about as urgent as a rerun of Law & Order.

But it’s worth spending a few minutes remembering what actually happened — and who got hurt.

The government’s case against Citigroup is about harms to investors who bought pieces of mortgage “pools” that Citi created. But since investors who buy mortgage securities aren’t exactly Joe and Jane Mainstreet, the whole thing can seem almost victimless. The financial press also tends to overlook the human costs and focus on the money: What does the $7 billion hit mean for Citigroup’s share price? (So far, investors seem happy to at least know the bill.) Who gets the money? (Mostly the government, but $2.5 billion will go to consumer relief, like mortgage modifications.) And who is paying? (Shareholders, basically. No individuals from the banks are paying up—at least in this settlement.)

So it’s easy to forget that actual homeowners were hurt, too. Citigroup was one link in a chain that turned home loans into investment products. At one end, there were the original mortgage lenders (including such fine operation as Countrywide). Citigroup would buy mortgages from the originators and then pool the loans together to create securities that other investors could buy. One of the bank’s jobs was to make sure that the mortgages in the pool were up to snuff.

Citigroup hired outside companies to check on this. The companies would look at a sample of the loans and see if any of them didn’t fit guidelines, or if valuations of the homes the mortgages backed looked squishy. The news Citigroup got back wasn’t pretty. One Citigroup trader looked at the reports produced and wrote in an email (one for the ages) that “we should start praying… I would not be surprised if half of these loans went down.” Nevertheless, Citigroup went ahead and created securities out of the loans. These securities went south, touching off the Great Recession.

But things didn’t work out terribly well for the individual borrowers, either. Citigroup and institutions like it helped stoke mortgage originators’ appetite to lend to just about anybody and everybody, in many cases based on unrealistic valuations. The damage from this includes borrowers who ended up overstretched and put on the road to foreclosure, and more broadly any home buyer who bought into a increasingly inflated market.

Let’s not forget that part.

MONEY

Does Anybody Need a Money-Market Fund Anymore?

New regulations are meant to protect money market mutual funds from another 2008-like panic.

On Thursday, the Wall Street Journal reported that the Securities and Exchange Commission is expected to approve new regulations for money-market mutual funds. Remember money-market funds? Before the financial crisis, these funds were very popular places to stash money because each share was expected to maintain $1 value. Your principal would remain the same, and the fund would pay substantially higher interest rates than a bank savings account.

But these days for retail investors, money-market mutual funds are something of an afterthought.

So why is the SEC intent on regulating them now? And will tighter rules push them further into irrelevance? Here’s what you need to know:

What going on?

A money-market fund is a mutual fund that’s required by law to invest only in low-risk securities. (Don’t confuse funds with money-market accounts at FDIC-insured banks. These rules don’t affect those.)

There are different kinds of money-market funds. Some are aimed at retail investors. So-called prime institutional funds, on the other hand, are higher-yielding products used by companies and large investors to stash their cash. The big news in the proposed rules affects just the prime institutional funds.

Prime institutional funds would have to let their share price float with the market, effectively removing the $1 share price expectation.

The SEC reportedly also wants to impose restrictions preventing investors from pulling their money out of these funds during times of instability, or discouraging them from doing so by charging a withdrawal fee. It’s unclear from the reporting so far which kinds of funds this would affect.

Why is the SEC doing this?

As MONEY’s Penelope Wang wrote in 2012 when rumors of new regulations were first circulating, the financial crisis revealed serious vulnerabilities to money-market funds. When shares in a $62 billion fund fell under $1 in 2008, it triggered a run on money markets.

In order to stabilize the funds, Washington was forced to step in and offer FDIC insurance (the same insurance that protects your bank account). That insurance ran out in 2009, and now the funds are once again unprotected against another run.

The majority of the SEC believes a primary way to prevent future panics is to remind investors that money-market funds are not the same as an FDIC-insured money-market account at a bank. Before the crisis, the funds seemed like a can’t-lose proposition. The safety of a savings account with double the return? Sign me up. But as investors learned, you actually can lose.

What does it mean for you?

Not much, at least not right away. The floating rate rules only apply to prime institutional funds, which the Wall Street Journal says make up about 37% of the industry.

The change also won’t be very important until money-market funds look more attractive than they do today. Historically low interest rates from the Federal Reserve have actually made conventional savings accounts a more lucrative place to deposit money than money-market funds. The average money-market fund returns 0.01% interest according to iMoney.net. That’s slightly less than a checking account.

Investors have already responded to money funds’ poor value proposition by pulling their money out. In August of 2008, iMoney shows there was $758.3 billion invested in prime money fund assets. In March of 2014, that number had gone down to $497.3 billion.

Finally, it appears unlikely that money-market funds will ever be as desirable as they were pre-crisis. As the WSJ’s Andrew Ackerman points out, money funds previously offered high returns, $1-to-$1 security, and liquidity. Interest rates have killed the returns, and the new regulations will limit liquidity and kill the dollar-for-dollar promise.

Don’t count the lobbyists out yet

Fund companies are really, really unhappy about the SEC’s proposed regulations. They’ve been fighting the rules for years, and until there’s an official announcement, you shouldn’t be sure anything is actually going to happen.

Others are worried the new regulations, specifically redemption restrictions, might actually cause runs on the market as investors fear they could be prevented from pulling money out if things get worse.

But the SEC may have picked a perfect time to do this. With rates so low, few retail savers care much about money-market funds. That wasn’t true back when yields were richer and any new regulation of money-market funds might have been met with a hue and cry from middle-class savers. Today? Crickets.

TIME Management

JP Morgan CEO Has Throat Cancer

Jamie Dimon told employees the disease is “curable”

+ READ ARTICLE

Investment banking firm JP Morgan’s CEO Jamie Dimon told staff Tuesday that he has throat cancer.

“The good news is that the prognosis from my doctors is excellent, the cancer was caught quickly, and my condition is curable,” Dimon, CEO of the bank since 2005, said in a note to staff.

Dimon said the disease will require about eight weeks of radiation and chemotherapy treatment, CNBC reports.

“I feel very good now and will let all of you know if my health situation changes,” he said.

Dimon steered JP Morgan through the financial crisis but met with controversy after the bank was involved in a scandal in 2012, leading to billions of dollars in losses and calls for Dimon’s ouster. The notoriously blunt bank chairman was criticized for calling the fiasco a “tempest in a teapot.”

[CNBC]

MONEY Housing Market

How to Stop the Next Housing Bubble

Housing development under construction on farmland, aerial view.
Housing development under construction on farmland, aerial view. Ryan McVay—Getty Images

The financial system is still too risky. Step one toward fixing that: Rethink mortgages.

More than five years after the Lehman Brothers collapse, America still has a bubble problem.

The economy is improving, but the country is still poorer and less busy than it should be this long after the official end of the Great Recession. Here’s where actual GDP lines up against where it might be if the economy had returned to its normal path:

image(25)
SOURCE: St. Louis Fed, Congressional Budget Office

Despite this gap, the Fed last week announced it was continuing to slow down its massive program of bond buying known as “quantitative easing,” which was designed to ease lending and goose the economy. The central bank is keeping short-term interest rates near zero, but many economists and economic pundits still think the Fed should be even more aggressive, rather than slightly less so. The Fed holds back mostly out of fear of inflation (which remains low) but another worry has emerged: Investors are getting cocky. Stocks are way up, bond investors are buying riskier stuff in a “reach for yield,” and yet a gauge of market mood called the “fear” index is registering an unusual lack of anxiety.

The Fed has expressed concern, at least in a keeping-it-on-our-radar way. “There is some evidence of reach-for-yield behavior,” said Janet Yellen on Wednesday in a press conference.

That doesn’t mean we’re in bubble territory. Even if a market drop is coming, there’s a difference between that and a systemic crisis like 2008’s; Yellen said she isn’t seeing a rise in dangerous financial leverage. But that we’re even having this conversation is a sign that there is a lot of unfinished business left over from the crisis. There’s still too much risk built into the financial system.

This story is the first in a series I’ll be writing for Money.com about ways to prevent future bubbles—or at least to limit the damage when they pop. There are numerous pieces to this puzzle. Banking regulations, consumer protections, Fed policies, and broad-based economic growth are all important for a healthy financial system.

But the most obvious place to start is literally close to home: Mortgages. The 2000s saw an enormous build up in household debt, largely driven by home loans.

SOURCE: Federal Reserve

A lot of attention has been paid to how crazy a lot of those mortgages were. There were “NINJA” loans (no income, no job or assets), no- or low-downpayment mortgages, and exploding ARMs that started with low teaser payments. Such loans are impossible or at least very hard to get now. But a pair of fascinating new books make the case that there’s still a basic flaw in how mortgages work, one that Washington had a golden opportunity to fix but failed to. Put simply, home loans are far too difficult to renegotiate when things go badly wrong.

Over the years I’ve read a tall stack of books about the financial crisis. Other People’s Houses, by Vermont Law School professor Jennifer Taub, provides the clearest, beginning-to-end explanation I’ve seen of what went wrong. And Taub’s beginning is a surprise: A 1993 Supreme Court decision about how bankruptcy law applies to mortgages.

A mortgage on your primary residence is different from other kinds of loans–and not in a good way. When a borrower is buried in bills, the bankruptcy process can help discharge many kinds of debt. In the early 1990s, Harriet and Leonard Nobelman found themselves underwater on a condo in Dallas—they owed more than $65,000, but the current market value had fallen to $23,500. As part of a bankruptcy plan, they proposed that the balance of their mortgage be reduced to that $23,500. The bank fought this in court. Ultimately, the Supreme Court decided that the principal value of a mortgage can’t be modified by a judge in the bankruptcy process.

Fast forward to 2008 and the housing crisis, and this technical-sounding decision suddenly mattered a lot. Candidate Barack Obama endorsed changing the bankruptcy law, but ultimately nothing ever came of it. And the administration resisted other proposals—coming from political conservatives as well as liberals—to encourage or push lenders toward principal reductions. (A program to subsidize some principal mods began in 2010.)

“Hang on,” you may be saying, “forcing people into bankruptcy doesn’t sound like much a solution. I know lots of people who went underwater on their home, and they never would have declared bankruptcy.”

That’s true. But Taub tells me that that this law matters even for those who never go to court. “It would have shifted the bargaining power,” she says. “Knowing that would be an option would have brought the lender to the table more quickly and more willingly.”

Of course, many underwater homeowners ultimately did get out from under their debts—by letting the bank take the house, or agreeing to a short sale and moving out. But could a more orderly, less painful principal reduction process have made the housing crisis less damaging?

Economists Atif Mian of Princeton and Amir Sufi of the University of Chicago say yes. Their book House of Debt argues that the Washington’s failure to help more homeowners renegotiate their debt needlessly prolonged the economic slowdown.

When households are weighed down by debt they can’t pay, they spend less, and the effect can spread throughout the entire economy. This seems intuitive, but most economists have preferred to focus on fixing broken banks. Mian and Sufi have found compelling evidence that homeowners’ woes were the real main event. For example, in U.S. counties with the sharpest declines in net worth during the crash, spending fell almost 20%.

Much of this is water under the bridge now. But not all of it. Taub points out that foreclosures are up over last year in some states. In any case, she argues that resetting the rules for how mortgages work could help to prevent the next bubble. “Hopefully, lenders, if they are disciplined by having to take losses, won’t engage in these no-money-down and no-doc mortgages and so on,” she says.

Letting off the hook people who borrowed too much is touchy stuff. (See Rick Santelli’s famous CNBC rant.) But if borrowers should be more cautious, so too should lenders. Although putting more risk on lenders might raise the cost of mortgages somewhat, Taub argues “that’s reasonable insurance to pay to avoid massive foreclosures and abandoned houses and the whole downward spiral.” You didn’t need to have an option ARM on an oversized house to feel the pain of the foreclosure crisis.

Mian and Sufi have another proposal for future mortgages that bypasses these hot-button fairness questions. A new kind of loan, called the “shared responsibility mortgage” could link mortgage payments to an index of local housing prices. If local prices fall, a borrower’s monthly nut would drop too. In return, the bank would get 5% of any capital gains on sale. The idea is both to ease the economic damage housing declines cause, and to give lenders an extra incentive to be careful about lending into frothy markets. (The tax code would likely have to be changed to make such loans popular.)

As Mian and Sufi point out, mortgages looked like a pretty safe investment from the point of view of lenders. That was a big part of the problem. Even if housing prices fell, lenders assumed homeowners would be obligated to make their full payments. But the economy as whole would have been safer if more of the risk was shared.

TIME Puerto Rico

The Next Financial Catastrophe You Haven’t Heard About Yet: Puerto Rico

On Tuesday, the island sold $3.5 billion in new debt. But the crisis still poses a danger to everyday U.S. investors

+ READ ARTICLE

Until recently, Puerto Rico was an investors’ tax heaven, renowned for its sandy beaches and killer rum. But the island is in dire financial condition and thousands of U.S. mom-and-pop investors may lose a big part of their savings if the small territory goes bankrupt.

It all started with an over-borrowing spree that lasted for decades. It ended with an island of fewer than four million residents accumulating $70 billion dollars in debt. That is a debt per capita of around $10,600 – or 10 times the median for U.S. states, according to the ratings agency Standard and Poor’s.

Puerto Rico’s over-borrowing was facilitated by an eager group of U.S. investors. U.S. mutual funds were more than willing to buy Puerto Rico bonds, because the island has a special financial advantage: its bonds are triple tax-exempt, which means that bondholders do not pay federal, state and local taxes for their coupon income (i.e. interest) from the bonds.

This created a large buyers base for Puerto Rico’s bonds, which encouraged the commonwealth to keep issuing debt. As a result, today around 70 percent of U.S. mutual funds own Puerto Rico securities, according to Morningstar, an investment research firm that specializes in data on mutual funds and similar investment offerings.

But Puerto Rico did not handle prudently enough this easy cash flow that was coming in. “For years, Puerto Rico practiced deficit financing, which essentially means taking out long-term debt to cover short-term financial needs; this was created by too much spending relative to revenues,” says municipal bond market expert Chris Mier, chief strategist at Loop Capital, an investment bank and advisory firm.

“This is unsustainable from an economic policy point of view in the long run, but since the ratings remained above investment grade, the buyers of the debt did not worry excessively,” says Mier.

The spark that lit the fuse came in 1996, when President Clinton repealed legislation that gave tax incentives for U.S. companies to locate facilities in Puerto Rico. The island’s economy began to sputter, and after the great recession, the decline in the island’s governmental finances continued.

At at time when the island is experiencing steady population loss and very low productivity, the unsustainability of unbalanced budgets and rapidly growing debt became increasingly evident.

Then the downgrades came: in the past several years, ratings agencies gradually downgraded Puerto Rico’s debt notch by notch. And the island’s government continued to promise investors that it would pass a balanced budget – something that has not occurred in over a decade.

To make things worse, a “brain drain” is occurring, as young qualified professionals are fleeing an unemployment rate of 15.4%, compared to the 6.6% federal unemployment rate, according to the U.S. Bureau of Labor Statistics. The fact that Puerto Ricans are U.S. citizens makes migration much easier and appealing, says Puerto Rican consultant Heidie Calero, president of Calero Consulting Group.

Currently, Puerto Rico’s population is 3.7 million on the island, versus 4.9 million Puerto Ricans living on the U.S. mainland. The U.S. Census Bureau projects that the island’s population will drop to 2.3 million in 2050.

“Around 51 percent of the island’s population is on welfare. How do you make them participate in the economy?” asks Calero. The size of the island’s “underground economy” was recently estimated at approximately $20 billion; and that is just an approximation since nobody really knows how much revenue goes unaccounted for, says Calero.

In February 2014, all three major ratings agencies downgraded Puerto Rico’s debt to below investment grade, widely referred to as ”junk” status in bond market circles. This indicates a greater risk of possible default or a debt restructuring. For U.S. investors, this means that the crisis in Puerto Rico will have a severe impact, not only on Wall Street but also on thousands of mom-and-pop investors.

The decline in market value of Puerto Rico bonds has reduced the value of investors’ holdings by at times as much as 35%, says Mier. But Mier cautions that there are many possible scenarios, including favorable ones where Puerto Rico succeeds in resolving its budget and debt problems and returns to investment grade ratings.

But to do that, the government needs to balance two seemingly conflicting goals: economic growth and fiscal austerity, says economist Carlos Soto-Santoni, president of Nexos Económicos, a Puerto Rico-based consulting firm, and deputy advisor for former Governor Rafael Hernández Colón’s administration.

In 2013 alone, the government passed $ 1.36 billion in new taxes. While this increases the government’s revenue, it makes doing business on the island more onerous – which in turn further impedes economic growth, says Soto-Santoni.

Solving the economic puzzle will determine whether Puerto Rico will be for the U.S. what Greece was for the European Union.

Ellie Ismailidou is a reporter for Debtwire Municipals

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