Financial Challenges in Puerto Rico and What it Could Mean for the U.S.

News about Puerto Rico’s financial challenges emerged this week out of seemingly nowhere, serving as a quiet footnote to larger worries about Greece and its likely exit from the euro.  Similar to Greece, it appears that Puerto Rico’s problems are systemic, having more to do with its growing reliance on exceptionally easy access to low-interest bonds financed by U.S. investors seeking a lawful way to avoid state and local tax obligations.  The New York Times explains:

For years, investors were lining up to lend Puerto Rico money, so it was easier to borrow than to fix any number of financial or structural shortcomings. Many of the lenders were middle-class Americans who knew little or nothing about Puerto Rico, but simply opted for one of the many tax-exempt municipal bond funds that have become popular.

Such funds have appeared to offer both low risk and a tax shelter. They have long catered to residents of higher-tax jurisdictions, like New York City, San Francisco and Philadelphia, where people pay three layers of income tax, to federal, state and local authorities. In other places, like Maryland and Indiana, the local income taxes are paid to counties, not cities, which makes them harder to escape.

For tax-weary residents, bonds issued by United States territories and commonwealths offer a unique way to avoid these taxes lawfully. Investors who buy these bonds can exclude the interest paid to them from their taxes, no matter what state they live in.

Perhaps most interesting is this quote by a managing partner at Municipal Market Analytics:

“This is the main problem with the muni market,” said Matt Fabian, a partner at Municipal Market Analytics. “We don’t worry, generally, about how bond proceeds are spent. We worry about how bonds are repaid.”

This is not an issue unique to Puerto Rico.  For the most part, bondholders do not care what the money is spent on; they only care about the terms for how the money borrowed will be repaid.  This creates a bit of a disconnect between the entity that is spending the money (states, cities) and the entity providing the capital (bondholders.) Bonds can be issued over a very long period of time and bondholders can sometimes lose track of what cities are doing with it.  This latest challenge in Puerto Rico seems to highlight this disconnect and shows that better, more constant communication between these two parties is sorely needed.  Furthermore, bondholders would do themselves a major service by asking tough questions of states and cities regarding their realistic expectations on future revenue streams. Perhaps more due diligence may help prevent more instances of this occurring in the U.S. and help state and local governments realize that our future infrastructure funding challenges is a revenue stream problem, not a financing one.



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