Why you can't ignore Puerto Rico's bankruptcy
Puerto Rico's bankruptcy is poised to threaten the livelihood of American citizens who planned their retirement on the island's promises, bludgeon investors and undermine state governments.
The bankruptcy may also provide hope of fiscal sustainability and improved services for Puerto Rico, as the U.S. territory attempts to dig out of $74 billion in debt and $49 billion in pension promises.
But the ripple effects remain shrouded in uncertainty as the U.S. judicial system runs, for the first time, a debt-cutting legal process known as Title III of a 2016 law dubbed the Puerto Rico Oversight, Management and Economic Stability Act (PROMESA).
"Nobody really knows exactly what’s going to happen," S&P Global Ratings credit analyst David Hitchcock said in an interview. "It’s highly uncertain."
To be sure, the legal process is similar to the Chapter 9 municipal bankruptcies of Detroit in 2013 or Orange County, Calif., in 1994.
An oversight board governing Puerto Rico will aim to negotiate debt-cutting deals with creditors with the goal of achieving a viable "plan of adjustment" that a federal judge deems reasonable and fair.
But previous municipal bankruptcies have demonstrated that the clash between Wall Street creditors, mom-and-pop vendors, retirees, politicians, union officials and special interests is a recipe for inertia.
"I don’t know that a dawn is coming, but it’s going to get darker," Municipal Market Analytics analyst Matt Fabian said in an interview.
What's clear, however, is that in the absence of action, Puerto Rico's downward spiral will continue, as the island's economy remains distressed and as thousands of people flee to the mainland.
© THAIS LLORCA, EPA People face off with police during the general strike against austerity measures, which coincides with the International Workers Day, in San Juan, Puerto Rico, on May 1.
To many Americans, Puerto Rico is a vacation spot and nothing more. But this bankruptcy could hit closer to home than they realize. Here's why.
Fellow American citizens could continue to suffer.
Puerto Ricans are American citizens. Their home is our home, and ours is theirs. They are suffering under the weight of heavy debt, government bureaucracy, high taxes and poor access to economic opportunity.
This bankruptcy may lead to their pensions and health care insurance taking hits, while services could also suffer cuts. Fabian estimated that some pensioners may get cuts of up to 20%.
But that may be necessary to help stabilize the island. Puerto Rico has lost 20% of its jobs since 2007 and 10% of its population, sparking an economic crisis that worsens by the day.
Still, without action to improve services such as public safety, health and education, the island's population loss could continue or even accelerate.
Your retirement investments may take a hit.
Since Congress voted 100 years ago to exempt Puerto Rican bonds from federal, state and local taxes, those investments have attracted many people seeking tax-free retirement income.
Despite years of trouble, more than 40% of U.S. municipal bond funds still have exposure to Puerto Rico debt, totaling $7.82 billion in holdings, according to Morningstar data provided to USA TODAY.
What's more, U.S. mutual funds hold about $8.38 billion in Puerto Rico debt, according to Morningstar.
Those bonds could be subject to steep cuts in bankruptcy, and while insurance may cover some of those losses, anyone who bet their portfolio on Puerto Rico should be nervous.
The bankruptcy "could have the advantage of a potentially global solution that might arrive more quickly and with lower legal costs, but it also strengthens Puerto Rico's protection against legal claims," Hitchcock said in a research bulletin.
It might be more expensive for your state to borrow.
Puerto Rico's crisis shows that large governments can reach a point of no return, endangering investment principal.
That may give investors pause before they acquire debt from cash-strapped states and cities, Fabian said. That could increase borrowing costs for state and local governments, which must cut spending or raise taxes to make up the difference.
"I think it will make life more difficult in places like Illinois and New Jersey and Connecticut, where investors are already reluctant to loan the government money," Fabian said. "It’s going to increase investor trepidation."
The case could lead to a political eruption in Washington.
Although Washington's response to Puerto Rico's action was largely muted Wednesday — it was, after all, not unexpected — the unintended consequences of PROMESA may soon trigger a political firestorm.
If and when discussion of pension cuts heats up, expect angry missives from members of Congress — perhaps even from lawmakers who voted to create this debt-cutting process in the first place. Others may be upset about bondholders taking cuts.
"Members of Congress have a variety of interests in what sacrifices are made in this restructuring," said Melissa Jacoby, a University of North Carolina professor and expert on municipal bankruptcy.
But don't expect a bailout anytime soon. President Trump has blasted the possibility of rescuing Puerto Rico, and it's highly unlikely Republicans on Capitol Hill will show any interest.