Puerto Rico is desperately trying to reorganize its $72 billion debt, but it faces a unique hurdle...
You see, it's an unincorporated territory, not a state. It can't actually declare Chapter 9 bankruptcy.
Without those legal protections, the Caribbean island is clearly sunk.
What isn't so clear now is the risk to mainland investors. There will be losses either way, but it's too early to say how big they'll be and how hard they'll hit.
Whatever happens there, we'll do well. The strategy I'm going to show you today offers protection and the potential for big profits as Puerto Rico's economy circles the drain...
There's Bad News... and There's Really Bad News
Puerto Rico's public debt load is $72 billion and rising.
Most of the municipal debt was issued by the Government Development Bank's subsidiary, the Public Finance Corporation (PFC). Utility, infrastructure, civic projects, and tax financing bonds were issued as revenue bonds, general obligation bonds, and moral obligation bonds.
Puerto Rico has been keeping up with most of its debts so far - but on Aug. 4, 2015, it paid only $658,000 out of a required $58 million payment due on some moral obligation bonds.
On the face of it, the Commonwealth breached its moral obligation to make timely payments on its debt.
Not making a full-interest or principal payment constitutes a default under most standard bond indentures. But the Commonwealth said it hadn't technically defaulted because moral obligation bonds issued by the PFC are paid by "appropriation of monies legislated by government," and there simply hadn't been enough money appropriated.
The rationale put forward was that in the future, sufficient monies could be appropriated and payments made.
Technicalities aside, Puerto Rico Gov. Alejandro Garcia Padilla said in June the debts are "not payable" and the island is in a "death spiral."
And its chances of getting bankruptcy protection are slim...
This is where Pedro Pierluisi comes in. He's Puerto Rico's Resident Commissioner to the House of Representatives. He can vote in committee but has no say whatsoever in what happens on the floor - that's down to the nature of the territory's constitutional relationship to the United States.
But Puerto Rico's situation is desperate, so Pierluisi is making a heavy back-channel push on other Representatives to get H.R. 870 passed - the bill that would allow Puerto Rico to declare bankruptcy. Senators Chuck Schumer (D-NY) and Richard Blumenthal (D-CT) introduced a companion bill in the Senate.
Proponents of the bill say it would allow the island to adopt U.S. bankruptcy laws and offer the island's municipal bond issuers an orderly restructuring process.
But big mutual fund companies, like Massachusetts' Mutual Financial Group, which owns Oppenheimer Funds and holds about $4.5 billion of Puerto Rico's paper in almost 20 different funds, are lobbying hard against Puerto Rico's effort to gain access to bankruptcy protections. So are other investment and hedge funds.
These opponents say the haircuts imposed in a Chapter 9 reorganization leave creditors exposed to substantial losses - just like those suffered by creditors in the bankruptcies of Detroit and Stockton, Calif.
What those opponents want is to let existing covenants in existing bond documents govern any post-default process. Currently, that process calls for the creation of a receivership at the request of bondholders. The court appoints a receiver who would have the power to fix utility rates so creditors could get paid back while services continue.
Under Chapter 9, courts don't have the same power to affect rates and can force creditors to take substantial losses in a plan to pay back some of the outstanding debt.
Here's How Regular Investors Get Hurt
About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.