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

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The spark that lit the fuse came in 1996, when President Clinton repealed legislation that gave tax incentives for U.S. companies to locate facilities in Puerto Rico.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