Puerto Rico might be a little too big to fail

Puerto Rico, with at least $70 billion in debt, confronts a rising economic misery

By Michael A. Fletcher

Boxes and wooden crates filled with household items bound for the U.S. mainland are stacked high in the Rosa del Monte moving company’s cavernous warehouse, evidence of the historic rush of people abandoning this beautiful island.

The economy here has been in recession for nearly eight years, crimping tax revenue and pushing the jobless rate to nearly 15 percent. Meanwhile, the government is burdened by staggering debt, spawning comparisons to bankrupt Detroit and forcing lawmakers to severely slash pensions, cut government jobs and raise taxes in a furious effort to avert default.

The implications are serious for Americans outside Puerto Rico both because a taxpayer bailout would be expensive and a default would be far more disruptive than Detroit’s record bankruptcy filing in July. Officials in San Juan and Washington are adamant that a federal bailout is not on the table, but the situation is being closely monitored by the White House, which recently named an advisory team to help Puerto Rican officials navigate the crisis.

The island’s problems have ignited an exodus not seen here since the 1950s, when 500,000 people left for jobs on the mainland. Now Puerto Ricans, who are U.S. citizens, are again leaving in droves.

They are choosing the uncertainty of the job market in Orlando or New York City or Philadelphia over what they view as the certainty that their dreams would be crushed by the U.S. territory’s grinding economic problems.

“We used to move a lot of machinery into Puerto Rico, and executives who worked in the pharmaceutical industry here,” said Neftaly Rodriguez, whose father founded Rosa del Monte. “Now we are packing people up to go out. Everybody is looking for a better opportunity.”

Puerto Rico lost 54,000 residents — 1.5 percent of its population — between 2010 and 2012 alone. Since recession struck in 2006, the population has shrunk by more than 138,000 to 3.7 million, with the vast majority of the outflow headed to the mainland.

The brutal combination of a long recession, a shrinking population and overwhelming debt has left Puerto Rico’s political leaders struggling to manage a conundrum: How do they tame at least $70 billion in debt while marshaling the resources to grow a shrinking economy and battle corrosive social problems, including a homicide rate that is nearly six times the U.S. average?

The crisis has left Puerto Rican Gov. Alejandro Javier Garcia Padilla juggling competing demands for budget cuts and other types of austerity demanded by Wall Street rating agencies, and the incentives and other spending needed to ignite growth.

“Sometimes, you are between the wall and sword,” Padilla said in an interview.

Not long after Padilla took office in January, Wall Street debt rating agencies downgraded the island’s bonds to just one rung above junk status. Like states, the commonwealth of Puerto Rico cannot file for bankruptcy. Also, Puerto Rico’s constitution offers bondholders strong guarantees that they would be paid before pensioners and public workers if the government went broke.

“I can assure you that Puerto Rico will not default,” Padilla said. “Puerto Rico will pay our debts. It is a constitutional obligation. But for me it is also a moral obligation.”

Still, with Detroit’s bankruptcy filing fresh in the minds of investors, the downgrade ignited widespread concern that the island was sliding toward default, which would hurt many investors across the United States. Because of their high yields and exemption from federal, state and local taxes, Puerto Rican bonds are held by three out of four municipal bond mutual funds, according to Morningstar, a market research firm.

“Some people might say, ‘This is their problem.’ But Puerto Rico is part of the United States, you own this problem,” said Pedro Pierluisi (D), Puerto Rico’s nonvoting representative to Congress. “It is not like you can ignore it.”

For now, the debt problems have done damage mainly in Puerto Rico, where it substantially raised loan costs for a government that has come to rely heavily on borrowing to fund its daily operations.

“You cannot pay daily expenses with your credit card, and that’s what Puerto Rico has been doing for years,” said Deepak Lamba-Nieves, research director of the Center for a New Economy, a San Juan think tank. “We borrowed just to keep the lights on.”

Puerto Rico’s expansive web of debt includes standard government bonds as well as those floated by public corporations, including authorities for water and sewer, highways and electric power. Together, those bills have nearly tripled since 2000, as successive administrations turned to the bond market to plug gaping budget deficits. In addition to the $70 billion in government debt, the government also faces $37 billion in unfunded pension obligations, according to Morningstar.

The explosion of borrowing coincided with a marked slowdown in the economy, and when a lucrative tax credit for manufacturers was phased out in 2006, the island fell into recession.

For decades, Puerto Rico’s economy was powered by U.S. firms that set up factories here that allowed them to tap a large, relatively low-cost labor market and to book profits under the favorable tax laws, while keeping cash-intensive research and development operations — and the accompanying big tax write-offs — on the mainland.

First, shoe factories and textile mills dominated the economic landscape. Later, pharmaceutical firms turned the island into a hub of drug manufacturing. According to one investor research report, 16 of the 20 top-selling drugs in the United States are made on the island.

But eventually many of the clothing plants moved to more promising ports. Then a series of key drug patents expired, contributing to a sharp decline in manufacturing. Since 1996, the number of factory jobs in Puerto Rico plummeted from 160,000 to 75,000.

And while government workers make up about a quarter of the commonwealth’s workforce — much higher than the U.S. average of 16 percent — their ranks are shrinking as the pervasive debt and economic problems careen toward a reckoning. Now, just over 41 percent of working-age Puerto Ricans are in a job or even looking for one.

Miguel Rodriguez, 50, who was working on his résumé at a government employment office in San Juan, said he has been out of work for four years, making it difficult to support himself or pay child support. He noted that his plight is not unusual. “Here, it is very hard to find a job,” he said.

As work has disappeared, more Puerto Ricans have relied on the government to survive: About a third of the commonwealth’s population relies on food stamps, and residents of the island are twice as likely as those on the mainland to receive Social Security disability benefits, according to researchers.

All of those problems were compounded by a housing bust that took down three of the island’s banks, while leaving many Puerto Ricans as deeply in debt as their government. Now pawnshops and title loan operations, which give loans to people who put up their car titles as collateral, are a growing presence on the island.

At a Borinquen Title Loans office located in a former bank branch outside San Juan, an employee inspected a potential customer’s car in the small parking lot, while inside, employees were busy on computers.

“We see all kinds of people here,” from former professionals to out-of-work laborers, said area manager Rosemarie Velazquez. “Business has been good.”

Restoring economic growth is a top priority for Padilla, whose signature campaign promise was to create 50,000 jobs. That would normally call for spending, tax cuts and investments. But his other top priority, bringing the debt under control, calls for the government cutbacks and tax increases.

Since taking office, he has tried to do both. Under pressure from the Wall Street rating agencies, his administration has enacted reforms far more dramatic than those made by cash-strapped states on the mainland.

He enacted $1.3 billion in taxes including increased corporate taxes, a broadened sales tax and a new gross receipts levy. The percentage increase in taxes is far larger than what the federal government has ever imposed, according to Richard Larkin, senior vice president of H.J. Sims, an investment firm.

“To say that Puerto Rico’s tax increase for 2014 was monumental is an understatement,” Larkin wrote.

Padilla also has continued government job cuts begun by his predecessor as governor. Together the two leaders have cut about one in 10 jobs from the public payroll.

The changes have put the government on course to shrink the current year’s budget deficit from an estimated $2.2 billion to about $870 million. The plan going forward is to reduce the deficit by half every year, and totally eliminate it by 2016, officials said.

To bolster the severely underfunded government pension plans, Padilla shifted many government workers from traditional pensions to 401(k)-type retirement plans, while raising retirement ages and increasing employee contributions to the plans. He also promised a series of increases in the government’s pension contributions to fortify the severely underfunded plans.

Meanwhile, economic development officials are stepping up efforts to generate growth on the island. The government has enacted tax incentives and offered electricity credits to entice firms that might be discouraged by Puerto Rico’s electricity costs, which are double the average on the mainland.

Officials also are searching for an operator for a $300 million port project that can handle the mega-ships that will soon traverse an expanded Panama Canal, and they are working to bolster the tourism trade, which accounts for a paltry 6 percent of the tropical island’s economic activity. They say they already are seeing success, including new air routes to the island and commitments to build hundreds of new hotel rooms.

“[Previously,] we were lazy and complacent,” said Alberto Baco, Puerto Rico’s secretary of economic development and commerce. “Now we have to act fast.”

But it remains to be seen whether the government’s actions will be enough to stave off the crisis. Earlier this month, the rating agency Fitch warned that Puerto Rico’s general obligation bonds could be downgraded to junk status next summer because of concerns that the commonwealth would be unable to return to the market anytime soon to borrow more at a reasonable cost.

Another downgrade would be a severe blow for Puerto Rico, effectively cutting it off from the market and paralyzing its efforts to dig out from under its mountain of debt.

If that happens, Lamba-Nieves, the director of the Center for a New Economy, said the federal government could feel pressure to step in with some type of bailout. “Puerto Rico might be a little too big to fail,” he said.