Puerto Rico Near Financial "Death Spiral"

In February, 2014, I blogged about Puerto Rico's impending fiscal disaster and its impact on the US municipal bond market. The financial earthquake from a likely Puerto Rican bond default appeared to be substantial. What changed between then and now? Until recently, nada.

In the past few days, Puerto Rico's rulers have thrown in the towel. According to a story in today's Washington Post (and elsewhere), the Commonwealth is $72 billion in the hole. Meanwhile, the debt meter is running without hope of repayment. Puerto Rico's governor has characterized the island's financial situation as entering a "death spiral." Ugh. Considering the majority of domestic mutual bond funds hold Puerto Rican paper, this scenario is a problem that could jar millions of American retail investors as well as institutional players.

The nearly certain Puerto Rican default, coupled with the Greek financial crisis, makes it a tough holiday week for high finance's Masters of the Universe. Predictably, Puerto Rico's governor has asked creditors to "share the sacrifices" the island's residents will soon be asked to endure. There has been no evidence to request has met any sympathetic ears.

$72 billion is a lot of money, even by today's tawdry standards. However, a little perspective might be helpful. In 2003 alone, the Department of Defense officially spent $54 billion on the second Persian Gulf war alone. Including operations in Afghanistan, the DoD raised the ante in 2004 to $70 billion. Those conflicts remain ongoing.

So does the Commonwealth of Puerto Rico's financial bleeding.

Wall Street KOs Puerto Rico Bonds: Why You Should Care

Standard and Poor's delivered a blow against Puerto Rico's key bond grade today. The commonwealth's general obligation bond rating is now below Wall Street's version of the Mendoza Line. Why does this matter? Many investment funds' charters allow purchases of those securities that make the investment grade, so to speak. Considering that, according to a story in today's Financial Times, nearly seven of every ten municipal bond funds include Puerto Rican bonds, the market is poised for a Humpty Dumpty-style great fall.

The Puerto Rican general obligation bonds possess two virtues: they're triple tax-exempt and they offer high yields. In a one-percent or two-percent yield environment, Puerto Rico's nine percent-and-climbing annual reward delivers a powerful incentive to invest. Today's S&P announcement questions the island's ability to repay its debts.

For all the happy talk about the recession being over, we now face the reality of municipal bankruptcies and political entities that require serious financial restructuring. Detroit and a posse of mid-sized California cities have cried fiscal "uncle." Philadelphia, Puerto Rico, and Chicago are not far behind. (By the way, Puerto Rico, unlike Detroit, cannot declare Chapter 9 bankruptcy.) It's an ominous trend for Americans contemplating mid-term Congressional elections and a lame duck presidency.