REAL TALK

Hey, Trump: Washington and Wall Street Broke Puerto Rico

The island is a colony by another name, denied basic rights afforded to states and preyed upon by bankers. Hurricane Maria was a 100-year disaster in the making.

President Donald Trump aggravated an already tense situation Thursday by blaming Puerto Rico for the chaos it faces after Hurricane Maria. While it’s clear that Puerto Rico’s failure to perform routine maintenance did indeed leave the island particularly vulnerable, in quoting journalist Sharyl Attkisson’s comment that “Puerto Rico survived the Hurricanes, now a financial crisis looms largely of their own making,” Trump ignores the significant role the federal government’s colonial policies, oversight failures, and funding mechanisms have contributed to the instability.

After the United States took Puerto Rico, Guam, and the Philippines from Spain in 1898, Congress looked for ways to pay operating expenses for the new colonies that minimized direct federal funding and that expressly allowed treatment unequal to that of states. A key component of this plan for Puerto Rico, signed into law in 1917, included creating a separate tax system outside the jurisdiction of the Internal Revenue Service. Residents pay no federal income tax and most corporations are exempt from many federal taxes. That allowed Puerto Rico to issue “triple tax-exempt” bonds, which are exempt from local, state, and federal taxes. By contrast bonds issued by states and municipalities are exempt at the federal level but not necessarily at the state and local levels.

After the Great Depression, mainland businesses, mostly small manufacturers, came to Puerto Rico, attracted by its large labor pool, low labor costs (Puerto Rico’s minimum wage was not equalized to the mainland until 1983), and duty-free access to the U.S. markets. By the early 1970s Puerto Rico’s economic progress had stagnated and  highlighted Puerto Rico’s inability to compete long-term with mainland states or to substantially grow its output or trade.

However, rather than working to alter the core issues of the economy that would have long-lasting effects, Puerto Rico instead turned to tax gimmicks. With Congress’ help, IRS section 936 was created in 1976 that allowed Puerto Rico’s companies the ability to transfer their income to their U.S. parent companies, tax-free. Mainland companies, particularly pharmaceuticals, flocked to Puerto Rico to take advantage of the scheme.

The program did not have the effect Puerto Rico had promised Congress it would, however. The federal treasury lost out on billions of dollars of tax revenues each year, yet Puerto Rico gained relatively few jobs.

Congress nonetheless played along. Always eager to avoid conversation on the tense topic of Puerto Rico—the United States has never extended the full Constitution to the island—Congress tweaked the law several times, but substantially left rule 936 in place until President Bill Clinton sought to balance the federal budget and phased it out beginning in  1996.

Soon after, Puerto Rico began to truly capitalize on its other unique power: to create bonds that were triple-tax-exempt.

Puerto Rico opted for easy money, which Wall Street was happy to provide.

The tax benefits these bonds provided to high-income individuals in high-tax mainland jurisdictions were unrivaled. The market’s insatiable appetite for investment vehicles with significant tax advantages created the perfect environment for uncontrolled borrowing.

Decade after decade, Puerto Rico hit borrowing limits and needed a workaround. Each time, instead of looking to change the fundamentals of the economy with the aim of stable but slow growth, Puerto Rico opted for easy money, which Wall Street was happy to provide.

Prior to 2000, the vast majority of bonds by Puerto Rico issued were traditional: debt tied to Puerto Rico’s constitutional guarantee and debt issued by Puerto Rico’s public corporations (e.g., power, water, highways).

With the eager help of investment bankers and an insatiable demand for triple tax exempt bonds, that changed in the new century: Puerto Rico began to aggressively expand its debt portfolio with novel debt instruments.

Exhibit A were bonds tied to Puerto Rico’s brand new sales tax. The bonds were issued in 2007 as Capital Appreciation Bonds—the “buy now, pay later” product of municipal finance—and were carefully constructed to allow Puerto Rico to borrow beyond limits outlined it its constitution.

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The significant reduction of U.S. military presence from the island in the early 2000s only worsened matters. Thousands of jobs and millions of dollars of direct and indirect spending were lost. Efforts to repurpose the Navy facilities have largely failed, and the economic contributions the military made to the economy have never been replaced.

By 2014 Puerto Rico needed to restructure a Gordian knot of debt instruments with incompatible and competing terms, a state of affairs much more comparable to nations than states—a whopping $73 billion in bonds and another $30 billion in unfunded pension liabilities. Only New York and California have more debt.

Were Puerto Rico a state, the normal course of events to restructure the debt would have been that followed by Michigan when Detroit found itself with debt it could not repay: U.S. Bankruptcy Court.  

Several things precluded Puerto Rico from going down this path: First and foremost was that Puerto Rico was removed from Chapter 9 eligibility of the 1984 U.S. Bankruptcy Code by an unknown party for unknown reasons. When Congress reluctantly took up the issue of Puerto Rico’s debt in the fall of 2015, it could have have simply reinstated Puerto Rico’s eligibility for Chapter 9, which was the strategy favored by many bankruptcy legal professionals. Legislative leaders decided against that, however, and eventually settled on a controversial law it titled "Puerto Rico Oversight, Management, and Economic Stability Act”, the English acronym of which spells the Spanish word for “promise” (“promesa”).

Were Puerto Rico a state, the normal course of events to restructure the debt would have been that followed by Michigan when Detroit found itself with debt it could not repay: U.S. Bankruptcy Court.

The law is a messy colonial hybrid--part federal bankruptcy law, part territorial management--and is possible only because of Puerto Rico’s unique status. Were Puerto Rico a state, Congress’ hands would have been bound far tighter: states are considered co-sovereigns under American federalism.

On July 1, 2016, the day after President Barack Obama signed the bill into law, Puerto Rico defaulted on $1 billion in constitutional debt. Not only was this the largest default in US municipal bond market history, it was also the beginning of the largest municipal debt restructuring process in U.S. history (Puerto Rico’s total handily eclipsed Detroit’s $18-20 billion record).

The past 15 months have seen the awkward and controversial machinations of an untested law playing out in a court not ideally suited to the task (Congress expressly placed jurisdiction in the U.S. Federal District Court, instead of the more traditional U.S. Bankruptcy Court).

That said, much of the infrastructure and assets behind the debt were destroyed by Maria. For example, PREPA, the island’s power company borrowed $8 billion largely to fund infrastructure that will now have to be rebuilt from scratch. Nearly three weeks after Maria’s landfall, 90% of households remain without power. Despite herculean private, public, and military efforts underway to restore services, most islanders will remain in the dark for months.

The federal courts, political leaders, and bondholders were already struggling prior to the storm to balance the repayment of existing debt with the need for a socially and economically stable society. The need for billions to rebuild obviously makes that challenge more difficult.

But it’s not just a question of dollar amounts.

In 1917, to avoid providing direct funding for the island, Congress unintentionally created an environment ripe for fraud, corruption, and that allowed for the accretion of massive debt. Congress’ actions one hundred years later will prove as significant; the way in which recovery is structured and funded will set the new rules via which Puerto Rico succeeds or fails in the decades to come.