Our Call: Capstone first wrote in September 2013 that the Commonwealth of Puerto Rico faced significant financial risks given its dependence on federal funding to help finance its operations. In subsequent notes, we highlighted additional risks, including Puerto Rico’s propensity to overspend budgets and the sheer complexity of its capital structure. Our coverage led us to believe some form of financial restructuring was likely, although, at the time, Puerto Rico and other territories were specifically excluded from being eligible to utilize Chapter 9 of the US Bankruptcy Code, which covers municipal insolvency proceedings. In addition, we focused on the importance of federal funding to the commonwealth’s budget as the public health program that covers approximately two-thirds of its residents was heavily dependent on federal funding. Based on our research, we believed Congress would continue to provide the funding not only to prevent a collapse of the finances of Puerto Rico’s government, but also to encourage its residents to remain in Puerto Rico and not relocate to states like Florida and Texas.
Background: The Commonwealth of Puerto Rico is an unincorporated territorial possession of the US. It has its own constitution, government, tax code, and a legal system that operates within the framework of the US Constitution. Puerto Rico has been in a state of economic decline since at least 2005 and has generally spent more to fund governmental operations than it has gained in tax collections. Consequently, the commonwealth has repeatedly issued debt to fund operations. Puerto Rico’s Constitution is unique in the sense that it has weak balanced budget requirements that allow for the use of deficit financing as a source of revenue. However, because it has a constitutional limit on indebtedness, much of its debt was issued through various special-purpose vehicles and government instruments to evade the 15% limitation on general fund revenues that can be devoted to general obligation indebtedness in any one year. At the time of its insolvency, Puerto Rico, with approximately 3.5 million residents, was the third-largest issuer of municipal bonds in the country with more than $73 billion in bonds outstanding. The commonwealth also had in excess of $35 billion in unfunded pension obligations and very little visibility on spending, as it was never able to accurately track spending or adhere to budgets enacted by the Legislature. It is believed at times, the central government, which generated between $9 billion to $10 billion annually in general fund revenues, was overspending its budget by as much as $2 billion a year.
Our Rationale: Our overall thesis surrounding Puerto Rico was its financial situation was untenable and that significant sums of federal funding and political will to engage in a serious operational restructuring of the commonwealth’s government would be necessary to stave off default. The federal funding has largely flowed after Puerto Rico was hit by back-to-back major hurricanes in September of 2017. However, the political will to avoid default and institute major reforms did not exist in the years prior to the hurricanes. In 2015, then-Governor Alejandro García Padilla announced that “the debt was not payable” and began lobbying for Congress to pass legislation authorizing Puerto Rico to restructure its debts. From this moment on, our coverage focused on how this restructuring would work, which credits would be least and most adversely impacted by a future debt restructuring, and what role the federal government would have in supporting Puerto Rico’s economy and its ability to fund debt service obligations that would ultimately determine creditor recoveries.
Our Process: We conducted a rigorous review of public records, federal and territorial law, and potential legislative solutions to the commonwealth’s financial problems. We also met extensively with policymakers and other stakeholders both in Washington, DC, and San Juan to see what steps federal and local policymakers would take to deal with Puerto Rico’s widespread problems both before and after insolvency proceedings began in May 2017. Both the insolvency proceeding itself and federal involvement in providing assistance to Puerto Rico in the aftermath of the 2017 hurricanes have been part of our ongoing coverage. Federal disaster relief funding plays a significant role in the commonwealth’s economy, and it will likely continue to do so for at least the next several years.
The Outcome: Congress passed the Puerto Rico Oversight, Management and Economic Stability Act (PROMESA) in mid-2016 with the commonwealth formally entering a court-supervised insolvency under PROMESA in May 2017. We have followed this proceeding ever since, as the impact it has on investors will not be fully clear until the restructuring process is complete and all of Puerto Rico’s debt obligations are successfully restructured. We also are closely monitoring any and all additional actions that Congress takes to support the finances or economy of Puerto Rico, including ongoing hurricane rebuilding and recovery efforts that are largely funded by the federal government.