Lessons to Learn from Puerto Rico

Puerto Rico has a population close to Connecticut’s, with land area twice the size of Long Island’s, and a GDP near that of Mississippi. The country also has more debt than any other state in the US at over $70 billion, with the exception of New York and California. I’m not going to spend this memo discussing mundane investment cycles or economic conditions, but rather supply some perspective on the situation and what we can learn from it, not only in our investment portfolios, but also in our overall decision making. Puerto Rico is a colony in a post-colonial world despite its status in 1952 declaring the country to be a “free associated state” of the United States. Under this arrangement Puerto Rico is subject to all federal laws, though its citizens do not pay federal taxes. As such, they are not permitted to vote and have little influence over the political decisions that affect their lives. Puerto Rico does not have popular support for independence as a result of their political and economic dependence on the United States.

Setting the Stage: the Jones-Shafroth Act of 1917 and the Merchant Marine Act of 1920. Government Policies with Long-term Unintended Consequences

At the end of the Spanish-American war in 1898, Puerto Rico was ceded to the United States from Spain. Prior to this, Puerto Ricans enjoyed Spanish citizenship. However, after Puerto Rico was no longer part of Spain, the people of Puerto Rico lacked citizenship to their foreign sovereign. As Puerto Rico was not considered a country in its own right, its citizens also lacked Puerto Rican citizenship.

The Jones-Shafroth Act of 1917 granted United States citizenship to the people of Puerto Rico and created a legislative system that had a senate, a house of representatives and a US appointed governor. The act also exempted Puerto Rican bonds from federal, state and local taxes, regardless of where the bond holder resides. Through a combination of citizenship and extension of US laws, the act exposed Puerto Rico to mandatory conscription of the US military, precisely at the moment the US entered World War I. Puerto Rico effectively traded its manpower for citizenship and increased American capital flows.

The Merchant Marine Act of 1920, also known as the Jones Act, is a law that regulates maritime commerce in US waters and between US ports. A section of the law requires that all goods transported by water between US ports must be carried on US flag ships. US flag ships are constructed in the United States, owned by US citizens and crewed by US citizens and permanent residents. With Puerto Rico being an impoverished and isolated island state, this act limits the routes international shippers can take. The act harms the overall economy (including that of the US), to benefit narrow interests by increasing the overall costs of shipping. For example, ships built to satisfy the Jones Act cost more than ships built in Korean or Japanese yards. The intention of the law was not to sabotage the economic progress of Puerto Rico, but rather to ensure continued vibrant growth of the US maritime industry. The effect we see now is a state burdened by year over year declines in economic growth, overwhelming debt and a people dependent on both government jobs and spending.

Triple Tax Exemption: a Double Edged Sword

The bottomless demand to own Puerto Rican debt (before the country’s default) was certainly the result of the bonds’ tax status for US investors. In 1973, Puerto Rico used this to its advantage, issuing debt to balance its budget. Puerto Rico would have issued debt at higher interest rates without the triple tax exemption. For instance, a 9 year highway and transportation bond issued in 2007 had a yield of around 5.25%. The equivalent yield when adjusting for the highest tax bracket in an area with high state and local income taxes (e.g., New York City) would be around 10%, nearly double the rate at issuance. It would be hard to see a scenario where Puerto Rico would be able to both issue and service their debt for as long as they did, while paying interest at much higher rates.

The tax status of the bonds demonstrates the local government’s inefficiency, rather than a lack of available funds. The government has been known to under-collect taxes and publish its annual financial reports 15 months after the end of the fiscal year. It takes good management to stay out of financial trouble and operate efficiently. We have yet to see this out of Puerto Rico, despite capital flows coming from the continental United States.

The triple taxation exemption was used to Puerto Rico’s competitive advantage, allowing the debt to double over ten years. Puerto Rico sold bonds to pay for operating expenses and plug annual budget deficits – a tactic used by New York City in the 1970s that nearly caused bankruptcy. In fact, at that time President Gerald Ford did not bail out the city. Instead, he threatened to veto any bailout, warning that New York City’s problems were a microcosm of those facing the nation on a whole. In Ford’s famous speech he stated, “If we go on spending more than we have, providing more benefits and more services than we can pay for, then a day of reckoning will come to Washington and the whole country just as it has to New York City [and when] that day of reckoning comes, who will bail out the United States of America?”

If New York City was considered a microcosm to the United States in 1975, it’s a fair assumption that Puerto Rico is considered similarly to the United States now in 2015. History tells us not to make investments that rely on bailouts to be successful. They are not always fruitful. Ultimately, the teacher’s union of NY would go on to purchase bonds and fill the budget gap. New York learned that it could go to the edge of bankruptcy and the federal government would simply let it occur. It seems likely that Puerto Rico will learn this same lesson.

Tax Incentives Are Not a Reason in and of Themselves to Invest

US investors did not properly assess the risks associated with investing in Puerto Rico as a result of its high yields relative to other US states and low yields relative to the risk it posed. There are many reasons why the risk premium on Puerto Rico should have been higher, despite the tax treatment of investments. The government began running budget deficits in the 1980s, which have been financed exclusively with borrowed money. Puerto Rico is like a consumer that uses one credit card to pay off another. Instead of cutting expenses, Puerto Rico used its tax status to further increase its debt. Pension plans have been massively underfunded for quite a long time – currently they are only approximately 6% funded.  The state has an organization called the Puerto Rico Electric Power Authority (PREPA), which is government run power plants that are entirely oil based. For the sake of comparison, currently only about 15% of all the power plants in the US are run on oil alone. Oil has the least efficient operating heat rate compared to coal, natural gas and nuclear energy. If a company operated like the government of Puerto Rico, the market would assign a high risk premium to it for all of the above reasons. However, since Puerto Rico gives investors tax incentives to participate, the risk premium was mispriced in the Commonwealth’s favor.

Puerto Rico, like any other US state, is not entitled to the same bankruptcy proceedings as a municipality. This is why US municipalities issue debt, not the state itself. This lack of bankruptcy protection places Puerto Rico investors in limbo. Restructuring instead of filing for bankruptcy is a drawn-out process that is messy, includes lawyers and is time consuming. When investors purchase an asset solely for its tax benefits, they focus more on the tax aspects rather than the price paid for the investment. By focusing on value and buying great businesses or entities for less than they are worth, investors will see more success than if they had invested solely for tax purposes.

USD Denominated Debt – a Problem for Puerto Rico Much Like EUR Debt for Greece

Seven years after the global financial crisis, the United States is still printing its way out of its struggles. In terms of monetary policy, Puerto Rico does not control its money supply, nor its coinage, nor its interest rates. It uses the US dollar as its currency and is thus subject to the Federal Reserve as its central bank, despite it not being a state. The Federal Reserve is currently running the “tightest” policy of the developed countries. Ultimately, this has caused the dollar to be very strong, further impeding Puerto Rico’s ability to service their debt. If Puerto Rico used its own currency, it would have the ability to issue debt in that currency, devalue its currency, and restructure its debt to prevent mass default. This is not something Puerto Rico is able to do and thus its situation mimics that of Greece. We have yet to see Puerto Rico negotiate with the Federal Reserve, much like Greece has with the ECB and the European Union.

The outlook in Puerto Rico is bleak. As a result of the Jones Act, Puerto Rico already has higher costs related to shipping and international commerce. Since the power plants operate as a state owned monopoly and are oil based, the Commonwealth also has one of the highest prices for electric power in the United States. The cost of doing business is further increased by complicated labor laws, forcing employers to pay for employee benefits out of their own pocket. Many skilled workers have migrated out of Puerto Rico, causing a stagnation in population growth. A strong dollar added to the mix makes it highly unlikely that Puerto Rico can compete on exports and grow its way out of its debt burden. The debt crisis is more than a fiscal one. Puerto Rico needs to address the structural problems holding back growth. Reform is in order, even if it will be slow, unpopular, and too “long term”.

Learning from Puerto Rico: Summary

1. We don’t make investment decisions that exclusively depend on a government bailouts or decisions. Investment outcomes are already unpredictable, without adding the impulsiveness of the government into the mix.
2. We don’t make investments based solely on tax treatment of assets. We evaluate assets for their fundamental merits. We worry more about the tax consequences of trading in and out of positions, rather than investing solely to avoid paying Uncle Sam.
3. We look for historical context to help us decrypt the current state of affairs, as well as to give us context for the future. This lesson applies to more than investments. If we don’t learn from our past mistakes, or the past mistakes of our ancestors, we ignore a great deal of insight that may help our present and future.
4. We shouldn’t buy things we can’t afford, hoping that we will make enough money later to pay for them. I wish this lesson applied to individuals alone, however governments seem to be most guilty of the “I want it, but I can’t afford it” syndrome.
5. Nothing happens overnight and psychology plays a major role in how we look at situations. It took Puerto Rico thirty years to get themselves into this mess. It will certainly take more than a year for them to get out of it. Investment returns work similarly. The value of our portfolio will fluctuate over time. However, over time the value will increase, even if it occurs slowly, unpopularly, and over too long a period of time.

Sources:

Energy Information – EIA.gov

Bond Yield Information – TD Ameritrade Institutional, Origin Wealth Advisers LLC Calculations

Tax Information – irs.gov

NY Federal Reserve 2011 Puerto Rico Report

GAO March 2013 Puerto Rico Report

GDP and Debt Information – bea.gov

Kreuger, A. – “Puerto Rico – A Way Forward”

Ford’s Speech - http://www.ford.utexas.edu/library/document/factbook/factbook.asp

Disclosures

This bulletin expresses the views of the author as the date indicated and such views are subject to change without   notice.

Our calculated perceived value is an opinion based on the information we have at the time of our forecast.  The risk assumed is that the market will fail to reach expectations of perceived value. Our opinions, forecasts or predictions of future events, returns or results are subject to change and are not guarantees of future events, returns or results.

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