On August 3rd, the island of Puerto Rico officially went into default on its $72 billion in debt. The announcement is the culmination of several years of economic woes, but the island's debt has now become an urgent problem for the US territory — and therefore, for the US.
The problem is especially tricky because US bankruptcy laws don't allow government institutions in Puerto Rico to declare bankruptcy, as those in US states can. US policy did a lot to create the problem, and people on both sides of the debate — Puerto Ricans and the creditors who own their bonds — are Americans.
The worst news: The island's fate is in the hands of Congress.
1) Puerto Rico is sinking under $72 billion in debt
Puerto Rico has been dealing with a worsening debt crisis for several years. It's been suffering economically since 2006, but thanks to a federal tax loophole it continued to be able to borrow money without people paying a whole lot of attention to its creditworthiness. As a result, both the main Puerto Rican government and its "public corporations" (like utilities) have racked up immense amounts of debt through bonds and tanked their credit ratings — even while trying to cut services and raise taxes. Now the Puerto Rican government is acknowledging that it's not going to be able to keep borrowing money just to pay off old debts.
So the question is whether Puerto Rico — either itself or its public corporations — will be able to declare bankruptcy and start working with a judge to restructure its debts. Congress is considering allowing some bankruptcy in Puerto Rico. But it's divided because many of the holders of Puerto Rican debt are American citizens and American investment funds.
2) Puerto Rico's economy has been struggling since 2006, when the federal government stopped offering business incentives
In the middle of the 20th century, the federal government wanted to encourage manufacturers that were tempted to move or expand to developing countries to move to Puerto Rico instead. But since Puerto Rico has the same labor standards as the US, that wasn't exactly appealing to businesses — especially when Congress decided in 1974 to bring Puerto Rico's minimum wage up to the rest of the US's, as well.
So instead, the government granted big tax breaks to businesses that had operations in Puerto Rico; starting in 1976, basically any profit a company could trace to Puerto Rico wouldn't be taxed. The tax breaks gave Puerto Rico a pharmaceutical industry.
This cost the US a lot of money in lost tax revenues, and in 1996 Congress decided to phase out the tax break. It officially ended in 2006, throwing Puerto Rico into a recession. (Many of the companies that benefited from the tax break moved to the Cayman Islands.)
That was swiftly followed by the Great Recession of the late 2000s, which basically kicked Puerto Rico while it was down. It's been struggling ever since. In 2013, 45.4 percent of Puerto Ricans were living in poverty.
3) People kept buying Puerto Rican bonds because of a quirk in the tax code
None of this sounds like a government you would want to invest in. And indeed, Puerto Rico's bond rating has been downgraded to junk level. But people continued buying Puerto Rican bonds even after it stopped being a good idea to do so.
The reason for this is, again, a federal tax break. Puerto Rican bonds are "triple-tax-exempt" — American companies and individuals who buy them don't have to pay federal, state, or local taxes on them. Typically, a municipal bond is only triple-tax-exempt if you buy it from the city where you live. But Puerto Rican's bonds are triple-tax-exempt for everyone. That made Puerto Rican bonds a particularly appealing investment opportunity — so appealing that people might not have looked too closely at the island's fiscal situation.
Right now, hedge funds hold about $15 billion in Puerto Rican debt, mutual bond funds hold another $11 billion or so, and individuals hold the rest. So the Puerto Rican debt crisis isn't just relevant to Americans because Puerto Rico is part of America — it's relevant because Americans are the ones owed the money.
4) Hundreds of thousands of Puerto Ricans moved to the mainland, worsening the economic crunch
Because Puerto Ricans are US citizens, it's easy for them to move to the mainland. So even when times were good in the 1980s and 1990s, more people were leaving Puerto Rico than arriving. And after the recession of the late 2000s, out-migration accelerated:
Immigrants in the US from Mexico, China, and India send a lot of money back to families back home (called remittances). Puerto Rican emigrants in the US don't — partly because an American dollar doesn't go as far on an island that also uses the American dollar as it does in a developing country, partly because it's just as easy for emigrants' relatives to move to America as for emigrants to move back to Puerto Rico.
5) Puerto Rico is caught in a "death spiral" of emigration, tax hikes, and benefits cuts
Not only did Puerto Rico not benefit from remittance money from the emigration wave, the wave also escalated the country's fiscal crunch. With fewer people paying taxes, the island had to cut services and raise taxes to make its interest payments — which encouraged even more people to leave. The governor calls this a "death spiral."
And just because the government has openly declared it can't pay back its debts hasn't stopped it from hiking taxes and cutting benefits to try to make up some of the gap (or just to demonstrate to its creditors that it's acting in good faith). In late June — just after announcing it wasn't going to be able to keep paying its debt payments — it hiked its sales tax from 7 percent to 11.5 percent.
That's not going to make nearly enough revenue to pay off the debt. But it is going to make life even harder for Puerto Ricans. And it's hard to see a way out of it: Puerto Rico will continue to lose revenue that could be used to pay off its debts if its economy continues to decline. But the cost-cutting measures it's taking now are making an economic recovery less likely — and might cause still more people to leave the island.
6) An obscure federal law from 1920 makes everything more expensive
All of this is made worse by a 95-year-old federal law that makes it more expensive to ship goods to Puerto Rico.
Under this law, called the Jones Act, foreign merchant ships can't go from one port to another port within the US. For most of the country, this isn't a problem. But it means that ships coming across the Atlantic or up from the Caribbean can't drop off goods in Puerto Rico on the way to or from another US port. Instead, they drop off goods on the East Coast, and then an American ship has to bring them out to the island.
The extra cost of shipping everything through two different legs — or getting special shipments just for Puerto Rico — means almost everything on the island is more expensive than it should be.
7) It's not just the central government that owes money — it's also utilities and other public corporations
In total, Puerto Rico owes about $72 billion in debt. But those are actually a bunch of different debts bundled together — not just the Puerto Rican government's "general obligation," but also the debts from its various public corporations (including utilities), cities, etc.
The public corporations owe somewhere between $20 billion and $25 billion. In particular, the Puerto Rican Electric Power Authority (PREPA) owed over $9 billion as of 2014. (Other public corporations include the Government Development Bank and the Public Buildings Authority.)
In 2013, when Detroit declared bankruptcy (and Congress didn't do anything to save it), there was a momentary scare over Puerto Rico's bonds. But hedge funds swept in and bought a lot of the island's debt. Hedge funds now own a lot of PREPA's debt. Some analysts have speculated that the creditors are hoping it and other public corporations might end up getting privatized to help the government pay off its debts.
8) Puerto Rico can't declare bankruptcy. Neither can its cities or utilities.
US states can't declare bankruptcy. But "substate entities" within a state — like cities, judicial districts, or public corporations — can.
Puerto Rico also can't declare bankruptcy, but under US law neither can its "substate entities." If PREPA and other Puerto Rican public corporations were located in New York or California, they'd be able to declare bankruptcy — but because they're in Puerto Rico they can't.
In 2014, the government of Puerto Rico passed a law allowing public corporations to declare bankruptcy. Creditors were not pleased, and earlier this year, a judge struck down the law because it was trumped by federal law.
So without action from Congress, Puerto Rico could end up in a messy situation where individual creditors could sue to get their money back, which could prevent Puerto Rican public sector employees from getting their paychecks.
9) Democrats are pushing to allow limited bankruptcy; Republicans say it isn't enough
After declaring at the end of June that it couldn't pay its debts, the Puerto Rican government started asking Congress to allow the territory to declare bankruptcy. That hasn't gotten a lot of traction among politicians.
But some Democrats are willing to consider letting the island's public corporations and other substate entities declare bankruptcy, just as they could if Puerto Rico were a state. That's the option that both Hillary Clinton and Martin O'Malley have endorsed, as well as Republican candidate Jeb Bush. And a bill that's been proposed in both this Congress and the last one would do just that.
At best, this would allow Puerto Rico to work on a plan (through bankruptcy) for about a third of its debt. That wouldn't solve the problem. But it would definitely be a start.
Republicans have also considered the bankruptcy bill — the House Judiciary Committee held a hearing on it in May. As the crisis has become acute, congressional Republicans are saying that allowing bankruptcy "isn't enough," and that Puerto Rico needs to address the underlying issues that caused the crisis.
One reason for Congress to take up the bill is the forthcoming presidential election — specifically, the possibility of appealing to Puerto Rican voters in Florida.
10) Creditors argue that changing the bankruptcy laws is unfair
Other Republicans — as well as some of the creditors holding Puerto Rican debt — are opposed to letting Puerto Rican entities declare bankruptcy, period. They argue that Americans bought Puerto Rican bonds with the understanding that those bonds wouldn't be touched by bankruptcy — so their money was essentially guaranteed.
If PREPA, for example, were allowed to declare bankruptcy, it wouldn't be able to walk away from its debts entirely. But it would start a court process to determine when, how, and how much those debts will be paid back. Most likely, the creditors will end up having to take back less money than they owe — which, for reasons surpassing understanding, is called a "haircut."
The conservatives who oppose tweaking bankruptcy law to help Puerto Rico believe they're defending the everyday Americans who hold some of Puerto Rico's debt in their 401(k)s.
11) But if nothing changes, Puerto Rico is looking at a slow, rolling fiscal disaster
Now that Puerto Rico has started defaulting on its payments, however, it's in dangerous territory. Creditors might start suing Puerto Rico to get their money back — and asking a judge to make the territory start paying any revenue it gets to its creditors, rather than paying its public employees or paying any benefits to its residents.
This seems like an unlikely scenario — but something similar actually happened last year, when a federal court ordered Argentina's government to pay out a massive amount of money to an American hedge fund. The difference is that this time, the court can actually force Puerto Rico to follow through. The other difference: The creditors are Americans — but so are the people living under debt.