Puerto Rico Is Sinking In Debt: Why The Mainland Should Care

Victor Nava Staff Writer, Franklin Center
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The island of Puerto Rico has been floating in a sea of debt for quite a while, but now it appears to be sinking. Facing $73 billion in debt, the U.S. territory’s governor, Democrat Alejandro Garcia Padilla, is warning that the island can’t continue making payments on its public debt, and reports suggest Puerto Rico may run out of cash in July. To say the island is in rough shape would be an understatement.

The island’s debt obligation is about four times the size Detroit’s was back in 2013, when the city filed for federal bankruptcy protection—the country’s largest municipal bankruptcy case ever. Puerto Rico’s debt is actually greater than the debt of all U.S. cities to have ever filed for bankruptcy protection combined. Puerto Rico’s debt amounts to over $20,000 per resident and it has amassed more municipal bond debt per capita than any other U.S. state.

Unlike Detroit, the Island of Enchantment can’t declare bankruptcy to absolve its debts. Federal bankruptcy code prevents the island (and states) from filing bankruptcy. Puerto Rico’s two options are that it can continue to work out deals with creditors to refinance its outstanding debts, or it could push Congress for a bailout — which seems unlikely to happen.

With a bailout being out of the question politically, why should Americans here in the states worry about the economic situation on a tiny island with a population smaller than most U.S. states?

Puerto Rico is the third largest issuer of municipal bonds in the U.S. after California and New York. Enticing yields on these tax-exempt bonds made them attractive investments for American funds over the last few years despite the island’s economic struggles. Investment management firm Morningstar says half of all U.S. municipal mutual funds hold debt from Puerto Rico, that means that millions of Americans, many likely to be retirees, are invested in those funds with bonds at risk of default. Instead of retiring to Puerto Rico, many Americans may have to delay their retirements because of it.

The island’s pension systems are also woefully underfunded, reminiscent of many plans in the 50 states, and Puerto Rico has had to take on a lot of debt to continue funding those plans.

Puerto Rico’s best-funded pension plan is its teachers retirement plan, which is only 16 percent funded. Its worst-funded is its judges retirement plan, which is just 3 percent funded. As bad a shape as Puerto Rico’s pension plans are, some in the states aren’t doing very much better. The latest figures show that the Illinois Judges Retirement System is 28 percent funded and in Kentucky, their Employees Retirement System is only 25 percent funded — and both plans have been trending downwards since 2007.

Paying down pension debt through borrowing is a budgetary tactic that many state and local governments employ, but it’s a risky maneuver that doesn’t always pay off and can quickly leave municipalities drowning in debt.

Puerto Rico’s debt includes about $3 billion in pension obligation bonds, issued in 2008. Proceeds from the sale of pension obligation bonds are usually invested, and if the rate of return is higher than the cost of the bond, governments can make money off these kinds of bond deals that go towards underfunded pensions. But all too often, investment returns are poor and the results can be ruinous for local governments. Cities like Detroit, Stockton, and New Orleans have all been negatively affected by bad pension obligation bond deals.

As is often the case with governments that issue these kinds of bonds, Puerto Rico was already in financial trouble when it issued their pension obligation bonds, and they were issued at the worst possible time — right before the start of the financial crisis in 2008.

Like many U.S. cities, the Puerto Rican government also routinely spent more money than it took in, borrowing to fill the gap. Puerto Rico ran a budget deficit every year from 2000-2012, accruing billions in debt along the way. Dr. Adam Millsap, a research fellow at the Mercatus Center at George Mason University, notes that like other U.S. cities and states, Puerto Rico has received billions in intergovernmental grants from the federal government since 1975 — grants which reduce the incentive for local governments to get their fiscal houses in order and encourage wasteful spending.

The debt crisis in Puerto Rico will without a doubt have reverberating effects in the United States, even if Congress doesn’t bail them out. Millions of Americans will see their retirement investments hit hard, and we could even see an increase in Puerto Ricans migrating to the U.S. mainland as they flee the economic woes on the island. While it may be too late to save Puerto Rico, there is a lot that state and local governments can learn from this situation. Namely: taking on more debt to alleviate debt problems is rarely successful.

Victor Nava is a Staff Writer for the Franklin Center for Government and Public Integrity.