If you liked the government-sponsored spectacle of Fannie Mae and Freddie Mac, you're going to love what they did to Puerto Rico. It is a textbook example of policy error compounded by inattention and magnified by demagoguery. Yet despite the recent flurry of publicity, few people have even a cursory understanding of the crisis and its genesis.
The issue matters to investors, especially retirees, as nearly half of all U.S. municipal bond funds hold Puerto Rican obligations in jeopardy of defaulting.
Christopher HopkinsThe island became a U.S. territory in 1898 following the war with Spain. In 1917, Congress extended to San Juan an ominous promise: We are from the Government and we are here to help you. So began the saga approaching its climax today.
A passel of tax breaks and special exemptions passed by Congress were intended to stimulate economic growth in Puerto Rico. Most significantly, a 1976 law provided that any income from subsidiaries located in U.S. territories would be exempt from taxation. Another local provision granted deductibility of dividends paid by subsidiaries of foreign companies to their parent firms.
As might be expected, a flood of capital investment poured into the island economy, as Fortune 500 companies and large foreign firms rushed to build factories to churn out pharmaceuticals and electronics. By the early 2000s, Puerto Rico could boast 89 major drug manufacturing facilities making the protectorate the fifth largest pharmaceutical producer in the world.
Alas, the bubble was a chimerical artifact of a misguided and ultimately destructive policy. Starting in 1996, Congress changed course and phased out the tax giveaways over 10 years. One by one, the beneficiaries of the exemptions closed their plants, taking 80,000 jobs with them.
It gets worse. Congress granted additional tax privileges to debt issued by Puerto Rico, its municipalities, and its public utilities. Muni debt from the Commonwealth is triple tax exempt in the U.S., allowing the government and its entities to issue billions in additional borrowing at artificially low rates subsidized by U.S. taxpayers to paper over the growing fiscal calamity. Wall Street abetted the disaster, eagerly collecting $900 million in fees to bring $126 billion in debt to market since 2000.
Now the day of reckoning has arrived. Puerto Rico has languished in a desperate recession for nine years and is unable to pay its debt. Normally, a municipality in such dire straits would pursue relief under the federal bankruptcy laws, following the examples of Harrisburg and Detroit in negotiating with its creditors to restructure its debt. Turns out, Congress foreclosed this option as well, albeit accidentally.
In rewriting the federal bankruptcy code in 1984, a drafting error inadvertently excluded territories of the US from the laws that apply to the states in granting debt relief to distressed municipalities. Until recently, the issue was moot but is now a major impediment to Puerto Rican restructuring. Oops.
After years of wrangling, court challenges, and much misinformation, relief may be at hand. In a rare example of bipartisan cooperation, the House Natural Resources committee has cleared a package of reforms that avoids a taxpayer bailout and creates an oversight board to supervise the restructuring of Puerto Rico's debt. As in bankruptcy, all lenders would share in the losses, and the Commonwealth must adopt fiscal measures to deal with the long-term deficits. A vote on the floor of both houses is pending, and large bipartisan majorities are expected to support passage.
Washington policy on Puerto Rico has been a classic case of good intentions with disastrous unintended consequences. Congress deserves credit now for coming together to recognize prior errors and provide some hope for the Americans of Puerto Rico.
Christopher A. Hopkins, CFA, is vice president and portfolio manger for Barnett & Co. in Chattanooga.