Puerto Rico Default Is Coming and It’s Just the Tip of the Iceberg

Good morning Puerto Rico. Default is coming.

Legislation moving in Congress would set up an oversight board to guide the US territory through what essentially amounts to bankruptcy. It would not expend federal funds to bail out Puerto Rico, but would allow the island’s government to pay back debtors at less than 100%.

This is just a taste of things to come.

A default was unthinkable just a couple of years ago. The national obligation to repay what it owes was once considered almost sacrosanct. In 2013, Puerto Rico Gov. Alejandro García Padilla said paying back all of its debt was not only constitutional, but “a moral obligation.”

Times have changed, as the Wall Street Journal points out:

Though markets have met the event with a shrug, that shouldn’t diminish the significance of the moment. It underlines how much the stigma about government default has faded. Investors would be wise to build this risk into their calculations when lending to governments from now on, especially since arithmetic suggests more defaults are on the way. With less moralizing and more planning, both creditors and debtors will be better off.”

Investors have long-considered sovereign debt a “safe” investment. But in a sense, they were ignoring reality. Loaning anybody money carries with it some level of risk. A guarantee to repay is only as good as economic realities surrounding it:

The idea that repayment of debt is a moral obligation irrespective of cost has deep cultural resonance. Yet it has never been a good guide to reality. Even without access to formal bankruptcy, every heavily indebted country weighs the cost of repaying debt against the loss of confidence and creditworthiness that default entails. Promises, even those embedded in laws and constitutions, are always subject to economic facts on the ground.”

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Of course, investors and hedge fund managers are crying foul. They want bailouts because they don’t want to be left holding the bag. But as Peter Schiff has pointed out, they took on that risk. They should pay – not innocent taxpayers:

The bailout wouldn’t help Puerto Rico. It would enrich all of the hedge fund speculators who bought up that Puerto Rican debt for pennies on the dollar. What’s the point of using taxpayer money and funneling it to hedge funds through Puerto Rico? All Puerto Rico needs to do is restructure… Why impose the losses on American taxpayers? Impose them on the people who were dumb enough to buy those bonds. Don’t allow them to use their political connections to rip off the American taxpayer.”

Peter’s comments hint at a deeper truth. A system guaranteeing repayment with absolute certainty creates perverse incentives. Governments always have access to “easy money.” And then they do what governments do – squander it based on political calculations. That’s exactly what happened in Puerto Rico. Flush with cash, the government went on a spending spree. It ran up its total debt to $118 billion, or 172% of gross national income. Now it’s time to pay the piper.

Ironically, the hedge fund investors knew what they were getting into according to the WSJ:

It’s hard to know what is less sincere: the original pledge or creditors’ claims to have trusted it. The prospectus accompanying the 2014 issue listed 14 pages of risk factors, including this one: ‘New legislation could…entitle the Commonwealth to seek the protection of a statute providing for the restructuring, moratorium and similar laws affecting creditors’ rights.’ The buyers, mainly hedge funds, knew they were getting an 8.7% yield, 5.5 percentage points more than top-rated Maryland offered, by assuming a high risk of default.”

They probably assumed Uncle Sam would ultimately bail them out. Looks like that’s not going to work out so good for them.

This isn’t just about Puerto Rico. The rest of the world is heading in the same direction. Just look at all the debt the US government has run up. It’s not sustainable. So, buyer beware.

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