This article was published by The McAlvany Intelligence Advisor on Monday, January 4, 2015:  

Coat of Arms of Puertor Rico

Coat of Arms of Puertor Rico

When Mel Feder bought some of Puerto Rico's general obligation (GO) bonds in 2006, he was excited to learn that, as an American citizen, the eight percent coupon would be completely tax free: no federal, no state, no local tax liabilities. In his tax bracket that meant he was likely earning the equivalent of more than 15 percent on his money.

As the Fed continued its zero-bound interest rate policy, Feder, still hungry for yield, bought some more of those GO bonds in 2012. He paid par for them. Today they are trading, if buyers can be found, at about seventy cents on the dollar.

On Monday Feder will have another concern: that coupon might not be paid at all. Feder, living in Woodmere, New York, retired in 2008. He said: “I don't take – at least I didn't think I was taking a risk.” But with Puerto Rico facing default on $1 billion of its bonds on Monday, Feder is now asking, “Are we getting paid in January?”

Probably not. In his quest for yield he probably didn't read the fine print: his bonds are less secure than others whose payments are coming due on Monday, and Puerto Rico Governor Garcia Padilla is doing a “clawback” – a term used to describe stiffing some investors in order to pay others. A better term is “musical chairs” – Feder may be one of many left standing when the music stops.

Puerto Rico's has been artificially stimulated for nearly 100 years. Upon becoming a commonwealth of the United States in 1917, investors have enjoyed the tax-free advantage. Decades later rules were implemented granting pharmaceutical companies and other related businesses special tax breaks if they were to open up shop in Puerto Rico.

In 2006 those tax breaks for Big Pharma ended and many of them closed up their shops, laying off some 80,000 workers. Although the bond tax advantages continued, the island's economy never recovered. Today Puerto Rico has the population of Oklahoma with a GDP smaller than Kansas', but its debt load is larger than any state in the union except New York or California. Its rate is twice that of the states, it's poorer than Mississippi, two out of five residents live in poverty and the island's economy continues to shrink, as does its population. Some are calling it a death spiral.

The spiral was induced by a deadly combination: short-sighted politicians enabled by Wall Street. One example will suffice. When the Big Pharma tax breaks ended in 2006, the Puerto Rican government instituted a sales tax for the very first time. UBS, Citigroup, and Goldman Sachs saw their opportunity and they took it. Together with the government they created the Puerto Rico Sales Tax Financing Corporation, which issued bonds to be serviced by the new sales tax revenue stream. Called “Cofina,” it worked so well that the bankers and pols created the Puerto Rico Electric Power Authority, or “Prepa,” which issued its own bonds to be serviced by electric power revenues. Along the way, the bankers lined their own pockets with fees for the privilege, an estimated billion dollars since 2000, while inundating the island with more than $125 billion in new issues.

Here is just a partial list of other government agencies that issued their own bonds to satisfy yield-hungry investors like Feder:

–   The Puerto Rico Infrastructure Financing Authority;

–   The Public Finance Corporation;

–   The Highways & Transportation Authority;

–   The Convention Center District Authority;

–   The Government Development Bank;

–   The Public Buildings Authority;

–   The Employees Retirement System;

–   The Industrial Development Company; and

–   The University of Puerto Rico.

Last June Padilla issued a warning: his government was nearly out of money and was going to have trouble making some interest payments. By shifting some funds around he was able to make them. But that was then. His government owed $94 million on July 15 and another $140 million on August 1.

On Monday Padilla's government owes interest on a billion dollars of debt, and a simple balance sheet adjustment isn't going to be nearly enough to make those payments. So he is instituting the clawback, hoping it buys enough time for him to persuade Congress to allow his government to use Chapter 9 to rid his administration of those pesky payments.

That dream evaporated when Congress failed to include any such provision in the recently enacted $1.1 trillion government financing bill, so time is running out. The three credit agencies have already deemed nearly all the island's bonds junk, with a Moody's analyst predicting a complete default: “It's hard to say whether that happens [on Monday] or July 1, [but] we definitely see that on the horizon.”

Last Wednesday the U.S. Treasury stated that Puerto Rico's anticipated default on Monday “demonstrates the gravity of the commonwealth's fiscal crisis … Puerto Rico is at a dead end, shifting funds from one creditor to pay another and diverting money from already-depleted funds to pay both current bills and [bond] debt service.”

As economist Herbert Stein famously said, “If something cannot go on forever, it will stop.” For Puerto Rico, and bond investors like Feder, on Monday it stops.


New York Times: Puerto Rico Says It Will Default on Some Bonds

Bloomberg: Puerto Rico's Slide

Bloomberg: Puerto Rico to Default on $37 Million of Payments Due Jan. 1

CNN: Puerto Rico is on the brink of a big default

Background on Puerto Rico

The New American: Is Puerto Rico America's Greece?

Economist Herbert Stein's quote

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