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The Rule of Law in Puerto Rico: What Happens When the Rules Change?

Robert E. Amodeo
Head of Municipals

Executive Summary

  • Puerto Rico’s liabilities surpass the size of its economy, more than $70 billion in debt in addition to unfunded pension obligations that exceed $40 billion.
  • The Commonwealth recently signed a debt moratorium bill into law which could aggravate the risks in an already uncertain debt complex.

We all know that Puerto Rico has a severely challenged economy saddled with more than $70 billion of debt. However, the situation is even worse when you include unfunded pension obligations. Those liabilities exceed $40 billion. All combined, the island is encumbered with liabilities that surpass the size of its economy.

The Commonwealth’s challenge is to raise the rate of economic growth (highly unlikely in the near term) while taking credible steps to address its unsustainable debt and pension liabilities.

It is difficult to conceive how this small island, mired in fiscal stress, can grow out of its debt crisis. Long spells of high unemployment and low labor force participation have led to the atrophy of workers’ skills and experience in the workplace. Developing workplace skills and promoting economic growth will take time.

The island’s government acknowledges that it faces few options to improve its financial position without halting debt service. Governor Alejandro Garcia Padilla recently signaled this by signing a bill that gives the Commonwealth the authority to suspend all debt payments until 2017. This would obviously harm the bond holders and, may, in time, harm pensioners as well. There is ample precedent to suggest that pensioners’ benefits are at risk when their sponsors default on debt.

The recent passage of this bill is a complete turnaround for the island’s governor. All previous steps taken by the Padilla Administration have been aligned toward the same goal: to strengthen the general fund and Puerto Rico Sales Tax Financing Corporation (COFINA) while looking for opportunities to ensure the self-sufficiency of public corporations that provide essential services to island residents. Debts of public-sector corporations (electric, water and sewer, and highway) are not legal obligations of the central government, yet the new legislation intends to impair the corporations’ debt by fiat. Among other consequences, this could complicate the ongoing negotiations between the electric utility (PREPA) and its bondholders.

Most investors purchased Puerto Rico debt understanding the security of the bond and where they would stand should the specific issuer restructure. For example, the owners of Puerto Rico general obligation debt believed that they were protected by constitutional provisions. By contrast, owners of COFINA were guaranteed first claim on sales tax revenues that far exceed the debt service. Changing the rules in the face of financial distress is problematic, but sometimes necessary. A minimalist approach to Puerto Rico’s financial distress would create workout rules for the debt that is clearly insolvent without impairing other securities that are solvent according to their indentures. The government is taking a maximalist approach by folding all these debts into a single workout. If the Commonwealth continues along the path of indiscriminately impairing all Puerto Rico’s debt, it will limit its access to the debt market in the future.

These latest political developments have aggravated the risks of an already uncertain debt complex. Further complications arise from the US Congress, which is considering its own legislation to address Puerto Rico’s fiscal stress.

Western Asset currently has zero exposure to Puerto Rico debt.

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