Time to negotiate Puerto Rico’s debt

Given Puerto Rico’s present economic outlook, the island will be unable to pay its debt. Creditors need Puerto Ricans to stay put on the island and pay more taxes in order to fulfill the debt commitments. However, Puerto Rico is losing population at a rate of some 1 percent per year — not quite Detroit, but worse than Greece. It is time for the Puerto Rican government, creditors and the federal government to act according to their respective responsibilities.

{mosads}The main culprits for the present situation are the people of Puerto Rico and its elected officials. As such, Puerto Rico has taken unprecedented steps to shore up the situation with austerity measures over the last nine years, including spending cuts and tax increases, as well as pension reform.

These actions have not been enough. As of now, Medicaid health providers are owed money from services offered in March 2015 (presumably the period April to the present was paid); many taxpayers are owed their income tax refunds; school bus drivers are owed part of their spring 2015 services; and bondholders of appropriation bonds (the ones with the least legal protections) are owed a payment scheduled for August. Lack of capital investments and a drought combined so that at present, many San Juan residents and businesses are under strict water rationing with five days of dry taps each week.

The actions by Puerto Rico’s government contrast with those of creditors. Up until 2014, Puerto Rico bonds were rated investment grade and the consensus was that debt would be paid. Now the situation has changed, but creditors have been unwilling to negotiate debt discounts and have lobbied the federal government to back them up.

Creditors received a higher interest rate over other investment alternatives to compensate their risk. For example, the government-owned Puerto Rico Electric Power Authority (PREPA) issued bonds in 2013 offering attractive yields with covenants that if cash were short, PREPA would raise its rates. At the time, PREPA’s book value was negative.

Presumably, the financial markets priced in the yield the risk that if Puerto Rico’s economy contracted, electricity demand would decline. Presumably, they priced the risk that Puerto Rico, like just about everybody else, would set up a regulatory commission that would not allow unilateral rate increases by an electricity monopoly. Presumably, they priced the risk that the provisions of Chapter 9 of the bankruptcy law available to the 50 states could be extended to Puerto Rico. Now that some of these events occurred or could occur, some investors are claiming that when they bought the bonds, they were getting the premium returns but not the risk, and therefore, they should be paid in full regardless of actual events.

The proposal by PREPA bondholders is to use the market power of a monopoly electricity provider to increase electricity rates from the present levels by about 15 percent. The bondholders allege that the increase would be enough to pay 70 percent of the debt. This 70 percent would be converted into variable interest bonds in which Puerto Rico takes the risk of future changes in interest rates. The other 30 percent of debt would be converted into capital appreciation bonds (CAB) with no payment of interest or principal over 29 years, since, even after the rate increase, the money obtained would not be enough. Full payment of the CAB, with 29 years of accumulated and compounded variable interest, would be due in 2044, passed on to whoever remains in Puerto Rico.

This is not the way that financial markets work or rather, not the way they should work. Congress has, thus far, been oblivious to Puerto Rico’s plight and unwilling to act on the issue of Chapter 9 of the bankruptcy law so that PREPA and other government-owned corporations could file for bankruptcy.

In any case, Puerto Rico residents do not have to pay the debt. As American citizens, they can, and are, buying one-way tickets to the U.S. (They would rather stay in Puerto Rico if the outlook were somewhat better.) It is time for all stakeholders to sit down and agree on a road map out of the present predicament.

Feliciano is an economist and president of Advantage Business Consulting.