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How to Avoid Puerto Rico's Debt Crisis and Make Money on It

Interest-Rates / Global Debt Crisis 2015 Aug 18, 2015 - 10:38 AM GMT

By: ...

Interest-Rates

MoneyMorning.com Shah Gilani writes: Puerto Rico is desperately trying to reorganize its $72 billion debt, but it faces a unique hurdle…

You see, it's an unincorporated territory, not a state. It can't actually declare Chapter 9 bankruptcy.

Without those legal protections, the Caribbean island is clearly sunk.


What isn't so clear now is the risk to mainland investors. There will be losses either way, but it's too early to say how big they'll be and how hard they'll hit.

Whatever happens there, we'll do well. The strategy I'm going to show you today offers protection and the potential for big profits as Puerto Rico's economy circles the drain…

There's Bad News… and There's Really Bad News

Puerto Rico's public debt load is $72 billion and rising.

Most of the municipal debt was issued by the Government Development Bank's subsidiary, the Public Finance Corporation (PFC). Utility, infrastructure, civic projects, and tax financing bonds were issued as revenue bonds, general obligation bonds, and moral obligation bonds.

Puerto Rico has been keeping up with most of its debts so far – but on Aug. 4, 2015, it paid only $658,000 out of a required $58 million payment due on some moral obligation bonds.

On the face of it, the Commonwealth breached its moral obligation to make timely payments on its debt.

Not making a full-interest or principal payment constitutes a default under most standard bond indentures. But the Commonwealth said it hadn't technically defaulted because moral obligation bonds issued by the PFC are paid by "appropriation of monies legislated by government," and there simply hadn't been enough money appropriated.

The rationale put forward was that in the future, sufficient monies could be appropriated and payments made.

Technicalities aside, Puerto Rico Gov. Alejandro Garcia Padilla said in June the debts are "not payable" and the island is in a "death spiral."

And its chances of getting bankruptcy protection are slim…

This is where Pedro Pierluisi comes in. He's Puerto Rico's Resident Commissioner to the House of Representatives. He can vote in committee but has no say whatsoever in what happens on the floor – that's down to the nature of the territory's constitutional relationship to the United States.

But Puerto Rico's situation is desperate, so Pierluisi is making a heavy back-channel push on other Representatives to get H.R. 870 passed – the bill that would allow Puerto Rico to declare bankruptcy. Senators Chuck Schumer (D-NY) and Richard Blumenthal (D-CT) introduced a companion bill in the Senate.

Proponents of the bill say it would allow the island to adopt U.S. bankruptcy laws and offer the island's municipal bond issuers an orderly restructuring process.

But big mutual fund companies, like Massachusetts' Mutual Financial Group, which owns Oppenheimer Funds and holds about $4.5 billion of Puerto Rico's paper in almost 20 different funds, are lobbying hard against Puerto Rico's effort to gain access to bankruptcy protections. So are other investment and hedge funds.

These opponents say the haircuts imposed in a Chapter 9 reorganization leave creditors exposed to substantial losses – just like those suffered by creditors in the bankruptcies of Detroit and Stockton, Calif.

What those opponents want is to let existing covenants in existing bond documents govern any post-default process. Currently, that process calls for the creation of a receivership at the request of bondholders. The court appoints a receiver who would have the power to fix utility rates so creditors could get paid back while services continue.

Under Chapter 9, courts don't have the same power to affect rates and can force creditors to take substantial losses in a plan to pay back some of the outstanding debt.

Here's How Regular Investors Get Hurt

There's a lot at stake if Puerto Rico defaults outright and can't pay back its debts.

A lot of the bonds were purchased by local credit unions in Puerto Rico, investment companies, and individual investors on the island.

Losses in a default or as the result of haircuts could further devastate Puerto Rico's future prospects. It would also hit the financial solvency of a lot of its citizens who had money in those credit unions or were invested in those high-yield bonds.

And the fallout of Puerto Rico's debt crisis travels to investors who might not realize how exposed they are…

Stateside, investors who bought individual Puerto Rican muni bonds for their own accounts, investors in municipal bond mutual funds that own Puerto Rico paper, and hedge funds that speculated on the high-yielding bonds investors were selling as potential default neared are all at risk.

However, there's an insidious, systemic problem in play on the island – and on the mainland – that's crippling Puerto Rico's ability to do anything about this big problem.

Why Puerto Rico Can't Pay Its Debts

The great majority of municipal bonds issued by the PFC are general obligation (GO) bonds. GO bonds are backed by the taxing authority of the issuing body; in other words, the issuer has a general obligation to draw on its ability to tax the citizenry to pay creditors.

But the problem is the island's ability to collect taxes.

Researchers, island commentators, academics, and the majority of businesses in Puerto Rico claim the real problem is the island's minimum wage laws.

Puerto Rican employers have to pay the federal minimum wage, $7.25 per hour. That's significantly higher than labor costs incurred by all Puerto Rico's regional competitors for tourism, which is the island's principal revenue source.

That means Puerto Rico is more expensive to visit than, say, Mexico and almost all of Puerto Rico's Caribbean neighbors.

High wages deter businesses from hiring workers on the books. And that in turn creates a huge underground economy on the island – one that robs the government of taxes and pushes technically unemployed workers into unemployment and other social safety services nets that have to be paid for by taxes.

That's the negative feedback loop that Gov. Garcia Padilla was referring to when he said the island was in a "death spiral."

Without Chapter 9 protection, receivers could theoretically make good on any and every default by raising utility rates… and further impoverishing the territory's residents.

Or, the U.S. federal government could bail out Puerto Rico. That means U.S. taxpayers would be on the hook once again.

But fortunately, there's a way we can shore up our position and make some money while policymakers kick the can around and Puerto Rico's economy circles the drain.

What Investors Need to Do for Profits and Protection

Right now, it's absolutely critical that investors holding Puerto Rico bonds in individual accounts or in their municipal bond mutual funds calculate their potential exposure.

If that exposure exceeds your tolerance, exit now.

And if you haven't sold out already, it's important to develop an exit plan if muni prices keep falling.

The alternative is to cross your fingers and hope that…

  • Puerto Rico is allowed access to – and uses – U.S. bankruptcy laws; or
  • Somehow the losses or haircuts creditors have to take won't be greater than the losses bond holders have already been socked with.

Now, here's the profit play…

It's basically impossible to borrow bonds to short, so investors hoping to make money on Puerto Rico's crisis would do well to look at the companies insuring those bonds.

There are several of insurers in the game with varying degrees of exposure, but the easiest play here is Assured Guaranty Ltd. (NYSE: AGO). Those shares have already started to slide behind this unfolding debt crisis, and they have quite a bit further to fall before they bottom out.

The stock is trading at just under $26.60 at press time, and I like shorting this up to $29.96.

Like I said, if we do this, we'll make out just fine during the debt crisis, but U.S. politicians and policymakers need to recognize that Puerto Rico's death spiral is being made worse by anti-competitive, high-minimum wage laws. And that's not just happening in Puerto Rico… It could lead to the undoing of America's still-struggling economy.

Source :http://moneymorning.com/2015/08/17/avoid-puerto-ricos-debt-crisis-and-make-money-on-it-heres-how/

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