How did the debt crisis happen?
During the Spanish-American War in the late 1890s the U.S. military invaded the Spanish-owned island of Puerto Rico. After the war ended, the U.S. retained control, making the islands an unincorporated territory and the residents U.S. citizens.
In 1917, Congress passed the Puerto Rican Federal Relations Act of 1917 which, among other features, gave the territory “triple tax exemption” (i.e., local, state, and federal) on most Puerto Rican bonds. Because the bonds were exempt regardless of where the bond holder resides, this exemption made Puerto Rican bonds attractive to investors both on the island and the mainland of the U.S. The local and territorial governments of Puerto Rico were able to sell bonds as a way to balance the territory’s budget and fund municipal services.
Additionally, the island benefited from tax breaks for corporations that moved to the island. From the 1970s to the 1990s, numerous industries — from clothing to pharmaceuticals — moved operations to Puerto Rico. But Congress allowed those tax incentives to expire in 1996, which lead to an exodus of companies (and people) back to the mainland. This decline, combined with an economic depression that has lasted 11 years, reduced Puerto Rico’s tax base, leading government officials to issue even more debt to cover the shortfall.
In 2014, the debt-to-GDP ratio reached 68 percent, which drove concerns the island would default on the bonds it had issued. In February 2014, three American credit rating agencies downgraded the government’s debt to non-investment grade (i.e., “junk”) which made borrowing by the government even more difficult.
About half of Puerto Rico’s budget was going to service the debt, so the territory passed a law suspending through January 2017 payments to investors holding general-obligation bonds, sales-tax securities and debt from the island’s Government Development Bank, and other public agencies.
If this has been going on for years, why it is now in the news?
Early this month Puerto Rico defaulted on a principal payment of $399 million — the island’s largest default to date. That action prompted Congress to expedite a plan to oversee the problem. House Speaker Paul Ryan has said he’ll make the Puerto Rico rescue package a priority, though the lead has been taken up in the Senate by Democrats.
If Congress doesn’t act quickly enough the Supreme Court may intervene. According to Reuters, the Court is scheduled to “rule by the end of June on the validity of a Puerto Rico law that would allow the U.S. territory to restructure the chunk of its debt issued by public agencies, more than $20 billion, in a bankruptcy-like process.”
Can’t the municipalities in Puerto Rico that issued the bonds just declare bankruptcy?
No, at least not yet. Unlike municipalities in states (think: Detroit), cities in Puerto Rico are not allowed to declare bankruptcy. But Democrats in Congress have proposed legislation to “to treat Puerto Rico as a State for purposes of chapter 9 of such title relating to the adjustment of debts of municipalities.” However, Republicans in Congress say that they want to see the undisclosed economic data from the island and to address the problem’s root causes.
Is Puerto Rico’s problem similar to the crisis in Greece?
Yes and no. Some of the underlying problems (e.g., a weak tax base) are similar, but a major difference is that most of Greece’s debt is held by foreign countries while Puerto Rico’s debt is owned by individual investors, pension funds, etc. That makes it more difficult for the default to be absorbed.
Additionally, if Congress allows a default by a U.S. territory it could have an effect on state and municipal bonds, causing bondholders to seek higher yields to offset the risk. This would mean that state and city taxpayers would have to pay more to finance local projects.
Other than citizens of Puerto Rico, who will be most affected by a defaults on the bonds?
American investors, particular older people and retirees. The bonds were considered a safe investment so they are held by a large number of mutual funds. Over 20 percent (377 out of 1,884) of bond mutual funds own Puerto Rican bonds, according to data from Morningstar.
Because older people and retirees tend to hold more of their money in bonds, a default could affect their savings or retirement income.