This article was published by The McAlvany Intelligence Advisor on Monday, January 21, 2019:
Bond investors trusting big dog Wall Street bankers like Goldman Sachs are about to learn (or relearn) at least two very important lessons: 1) don’t trust them; and 2) don’t assume the U.S. government will bail you out if things go south.
Like they are in Puerto Rico.
The island’s debt crisis dates back to 1973 when the government began to spend more than what it collected. To cover the deficit, the government issued bonds rather than cut its budget. That practice continued for four decades until 2014 when the three major credit rating agencies downgraded several bonds issued by Puerto Rico to “junk status” after the government was unable to demonstrate that it would be able to pay its debt. The downgrading, in turn, prevented the government from selling more bonds in the open market.
That led to the bankruptcy filing and the restructuring agreement that Judge Laura Taylor Swain is about to rule on. She was put into this unenviable position back in 2017 by Chief Justice John Roberts as part of the overall plan to “restructure” the island’s debt.
It was going to be ugly, just as Swain said: “There is no decision that can perfectly reconcile all concerns.” Not even close. The primary revenue source to pay interest on Puerto Rico’s $74 billion in debt is the island’s sales tax. There are barely three million citizens living on the island, and more than 80 percent of them live in poverty. So the sales tax revenue stream comes primarily from tourists. [Correction: most of the sales tax – 11.5 percent! – is borne by those living in poverty.] It turns out that that revenue stream has been overcommitted, some of it illegally, in order to support the government’s profligate spending.
All Swain has to do is approve the agreement cobbled together since the island’s government declared bankruptcy in 2017. Some 8,000 bondholders, negotiating with the board established by Congress under the Puerto Rico Oversight, Management, and Economic Stability Act (PROMISA), would reward senior bondholders with a return of 93 percent of their original investment while junior bondholders (arranged by Goldman Sachs and local investment firm Santander Group and then sold to their investors) would get just 56 percent. Some $6 billion of that debt will be canceled altogether, leaving those investors with nothing.
Brian Chappatta, writing at Bloomberg, has little sympathy for Wall Street:
Wall Street played a big role in Puerto Rico’s spiral toward bankruptcy. Banks were happy to collect juicy fees for underwriting debt sales and encouraging the use of new revenue streams to back securities….
Mutual funds and high-net-worth individuals, for their part, snapped up the bonds because their interest payments were exempt from federal, state, and local government taxes. And, of course, local politicians were all too willing to borrow into an eager market.
Those investors weren’t concerned about the safety of their investments in Puerto Rico’s rickety economy, thinking that since Goldman and local investment bank Santander Group had put the bond offerings together they had nothing to worry about. And besides, if something came undone, since the island is a U.S. “commonwealth” where its citizens hold U.S. citizenship (although they cannot vote), Congress would, if worse came to worst, bail them out.
Enter The Donald. During “The Sean Hannity Show” in October 2017, Trump said “They [the Puerto Rican government] owe a lot of money to your friends on Wall Street. We’re going to have to wipe that out. That’s going to have to be – you know, you can say goodbye to that.”
Now those investors are being forced to consider the first rule of investing in bonds: “more important than the return on your money is the return OF your money.”
Judge Swain took testimony over the proposed agreement for two days last week, and will make a decision shortly. It’s likely to involve issuing more tax-exempt bonds to cover the shortfall, with payments to continue to 2058.
Her decision leaves in limbo the remainder of the $74 billion in indebtedness and says nothing about the $49 billion in unfunded pension liabilities.
This leaves investors learning another lesson: when dealing with big dog Wall Street banks, watch out for big fleas.
AmericanThinker.com: Puerto Rico bankruptcy decision a Death Star for Wall Street
The Wall Street Journal: Puerto Rico’s $18 Billion Bond Restructuring Nears Completion
Bloomberg.com: Puerto Rico Tests the Trump Strategy to Wipe Out Debt