The great economist Hyman Minsky coined the term "Ponzi finance" to describe the situation when borrowers use more borrowed money to pay their debts.
The U.S. government engages in Ponzi finance every day since it is incapable of repaying the more than $17 trillion it has borrowed.
On a smaller scale, the Commonwealth of Puerto Rico has been engaging in Ponzi finance - but unlike the United States, Puerto Rico can't simply keep printing more money to pay its debts.
In recent weeks, it has become apparent that Puerto Rico and the holders of its municipal bonds are going to have to pay the piper...
These Bonds Obscured the Inevitable
Earlier this year, with much financial media fanfare, Puerto Rico sold $3.5 billion of 8% Series A General Obligation Bonds due July 1, 2035. The underwriters priced the March 11, 2014 bond offering at 93 cents on the dollar in order to provide buyers - which were mostly favored accounts like hedge funds and large mutual fund bond complexes - with what we in the business call a "quick flip."
The bonds traded as high as 100 after the sale before settling down to the mid-90s. The bonds are currently trading at 85 and regulators are looking into how the deal was sold.
Puerto Rico is hopelessly insolvent. The island has $73 billion of debt, more per capita debt than any municipal entity associated with the United States. It has no industrial base and tourism comprises a surprisingly small part of its economy. The island's economy has shrunk by 11% since 2006.
With no hope of ever repaying its debt, the March 2014 bond offering was used to repay some short-term obligations and let everyone pretend that Puerto Rico is not bankrupt for another couple of years.
Recognizing the inevitable, however, in late June the governor of Puerto Rico proposed legislation that would allow the Commonwealth's public corporations to restructure their debts through a process similar to bankruptcy.
This proposal broke an unwritten understanding that these public corporations were acting as conduits for the Commonwealth and were treated as benefitting from both the backing of the Commonwealth and the specific revenue streams of their businesses. The proposed legislation is being seen as breaking that compact and leaving investors in the corporations without the ability to rely on the backing of the Commonwealth.
In the aftermath of the Governor's proposal, Moody's Investor Service downgraded Puerto Rico's general obligation bonds to B2 from Ba2 and its sales-tax debt to junk status. Long-term bonds of its troubled electric utility, Puerto Rico Electric Power Authority (PREPA), have traded down to the 40s. Investors are recognizing what they should have realized a long time ago - these corporations are likely to default.
Investors who relied on the backing of the Commonwealth for their Puerto Rican corporate bonds were fools.
Not to put too fine a point on it, but investors in Puerto Rico's general obligation bonds were also fools, including and especially those who bought the March 2014 issue (other than those favored investors who were able to buy the new issue at 93 and flip it to greater fools at higher prices before it plunged in price).
Wealth Managers Should Be Ashamed for Not Spotting This
The allure of a triple-tax-free bond paying a high after-tax rate of interest in a functionally solvent municipal credit is a classic sign of late-cycle investor behavior. Puerto Rico is hopelessly insolvent. The Governor's proposal to subject Puerto Rico's corporate entities to a bankruptcy-like procedure is the only way to responsibly address the island's debt crisis.
Until massive amounts of debt are written off and the Commonwealth and its businesses are put on a sustainable path, investors are deluding themselves into thinking their debt will be repaid. Managers who have been buying this debt for their retail clients should be ashamed of themselves.
It is one thing for hedge funds and other professional investors to take these kinds of risks, but those wealth managers charged with protecting retail and high net worth money should have known better.
This is going to end very badly, and should serve as a cautionary tale of how debt heaped upon debt, even to a U.S. Commonwealth, ultimately meets its reckoning...