Puerto Rico and the Bond Market: An Unpleasant Truth

Ever since Detroit filed on July 18, 2013 for protection of Chapter 9 of the Bankruptcy Code, municipal bonds, especially those of Puerto Rico, have taken a beating. According to Bond Buyer of October 24, 2013, PR muni yields have spiked since a front page article on the commonwealths finances in Barrons on August 26. Some of them have effective interests rates well over 8%. This has awoken an interest in the financial media in the islands economy. Although the market for PR munis has stabilized after the October 15, 2013 Government conference call, the yields are still high. With $70 billion in debt, a dwindling population and stagnant economy investors are now pondering the possibility the island could be unable to pay its debt. This is reflected by an increasing call for Washingtons involvement in PRs finances. The Economist in its October 26 issue calls for Washington to provide interim finance assistance to assist restructuring, much as the IMF does elsewhere. Barrons Income Investment of October 24 mentions that CITI is encouraging the FED to introduce a program similar to the Temporary Liquidity Guarantee Program and Long-Term Temporary Refinancing Operations or providing Puerto Rico access to the Federal Reserves discount window would restore investor confidence in the islands bonds. The problem with this type of thinking is not only the moral hazard issue but also the impossibility of Congress or the President providing this relief to the unincorporated territory of Puerto Rico when it has done nothing for Detroit, to say nothing of financially strapped states. What then, can be done? In 1995, Washington DC was on the brink of being insolvent and as PR, none of its subdivisions is eligible for Chapter 9 protection, see, 11 U.S.C. 101(52). Congress enacted the D.C. Financial Responsibility and Management Assistance Authority, better known as the Financial Control Board that managed Washington DC finances from 1995 to 2001, see, http://www.washingtonpost.com/wpdyn/content/article/2011/01/30/AR2011013 003901.html The Board held the power to enact or override many of the actions of the mayor and helped straighten its finances. Can the same be done with Puerto Rico? Article I, section 7(17) of the Constitution gives Congress the power To exercise exclusive Legislation in all Cases whatsoever, over such District (not exceeding ten Miles square) as may, by Cession of particular States . . . This was the basis of Congress creation of the Board. Puerto Rico, since at least 1901 has been considered an unincorporated territory of the United States, see, Downes v. Bidwell, 182 U.S. 244 (1901). Article IV, section 3(2) of the Constitution states that The Congress shall have Power to dispose of and make all needful Rules and Regulations respecting the Territory or other Property belonging to the United States; and nothing in this Constitution shall be so construed as to Prejudice any Claims of the United States, or of any particular State. A perfunctory reading of these two sections shows their similarity. Moreover, in Harris v. Rosario, 446 U.S. 651 (1980) the Supreme Court

clearly stated that Congress, which is empowered under the Territory Clause of the Constitution, U.S. Const., Art. IV, 3, cl. 2, to "make all needful Rules and Regulations respecting the Territory . . . belonging to the United States," may treat Puerto Rico differently from States so long as there is a rational basis for its actions. But see, Boumediene v. Bush, 553 U.S. 723 (2008). Although Puerto Rico has self-government, so did Washington DC in 1995. Hence, it is entirely constitutional for Congress to create a Financial Board for Puerto Rico to direct its finances. The question would be why? Aside from its high debt and low growth, Puerto Rico has other structural deficiencies. The Economist of October 26 states Like Greece, Puerto Rico is a chronically uncompetitive place locked in a currency union with a richer, more productive neighbor. The islands economy is also dominated by a vast, inefficient near-Athenian public sector . . . Puerto Ricos priority should be structural reforms to boost growth, breaking up monopolies to reducing red tape. For example, Puerto Ricos electricity production and distribution is a state monopoly, the Puerto Rico Electric Power Authority, which according to its 2012 Financial Statement has $550 million more liabilities than assets. The Puerto Rico Aqueducts and Sewer Authority is in a similar situation and both are in the process of adding, not displacing, employees. Both of these monopolies are also bond issuers. Moreover, the present Governor has made it clear that he does not contemplate ending the monopoly or privatizing the agencies. Puerto Ricos financial situation has sparked Governmental interest. Although the 2011 Report by Presidents Task Force on Puerto Ricos Status speaks about coordinating financial support with the Federal Government, no one had heard of it being done until rumors of a Federal receivership for the island surfaced during the summer. Puerto Ricos government officials admitted there were conversations and advice, but nothing more. This, however, is unprecedented in the recent history of the PR-Federal Government relations and unheard of between a state and Washington. There is other evidence of federal concern with the islands debt problem. Business Insider, Reuters and Bond Buyer, to name a few, all reported on October 24, 2013, that the SEC examiners as to PR bonds are reaching out to firms per usual to get a sense of their exposure and how they manage it. Reuters quoting John Nester spokesperson for the SEC. Why? According to Business Insider, Many funds-including 77% of muni bond mutual funds, according to [Michelle] Kaske- have huge exposure to the islands debt because it is tax free. Franklin Templetons Franklyn Double Tax-Free Income A fund comprises 61% Puerto Rico debt, and Oppenheimer Funds Oppenheimer Rochester VA Municipal A. contains 33% Puerto Rico debt, Bond Buyer reports. Bond Buyer also says that [s]ecurities law experts said the SEC probes appear to be aimed both at understanding potential effects on the market if the heavily-indebted commonwealth suffers a further downgrade or even a default. They also seem to be checking to make sure that funds investing in the bonds are adequately disclosing the risks involved in Puerto

Rico debt. Massachusettss top securities regulator, William Galvin, has voiced similar concerns and opened his own probe, mostly on Oppenheimer. It could be argued that the SEC is trying to prevent any systemic event like the ones in 2008 that could potentially rock shaky financial system. Pursuant to Dodd-Frank, the SEC or other parts of the Federal Government could move against any of the aforementioned private entities to prevent further damage, although Puerto Rico is not a financial institution. Seems to me that a Financial Commission to oversee PRs finances would be cheaper than rescuing these private entities. I am not arguing for a Financial Commission as in DC but simply pointing out what I consider better, cheaper and faster procedures to ensure the safety of the financial system. It is quite obvious that PRs debt is simply to high to be paid in the future given its economy and governmental structure. Change is needed but will not come from within. Hence, a Financial Commission to do what needs to be done. Moreover, investors must understand that not all of the debt Puerto Rico has issued has a Constitutional priority. The islands Constitution only protects the GO, which has been backed by the full faith and credit of the Commonwealth of Puerto Rico. According to page 56 of the Puerto Rico Government Development Bank of October15,2013, http://www.gdbpur.com/documents/UpdateonFiscalandEconomicProgressWe bcast-Final.pdf only about $16.223 billion are backed. Investors must take a close look at all the issues before deciding on how to convince Washington to do something.

s/John E. Mudd Like my Facebook Page: http://www.facebook.com/MuddLaw Follow me on Twitter: @MUDDLAW www.twitter.com/muddlaw LinkedIn: http://pr.linkedin.com/pub/john-mudd/32/433/a35/ johnmuddlaw@gmail.com