Some Common Cents for October 6, 2017

October 6, 2017, by John Norris

I started in this industry working on a buy-side bond trading desk, as well as managing money market and municipal bond funds. My employer in Baltimore had some pretty strict credit standards, and, as a result, we were not big buyers of Puerto Rican debt. This was a little unusual in the industry since the stuff ALWAYS had insurance which meant, at the time, it carried a triple-A rating. Further, due to favorable treatment from the IRS, Puerto Rican debt was tax exempt at both the state and Federal level, unlike most other municipal debt which is only state tax exempt for residents of the state of the issuer.

The general thought process was pretty simple: 1) the insurance was all but meaningless because none of the ‘muni issuers’ would have been able to fully cover a meaningful default, let alone a slew of them. Basically, it was more of a marketing add-on than a true credit enhancer, and; 2) the Puerto Rican economy wasn’t strong to support its appetite for debt.

Even if he might not have actually said it, I remember our head credit guy, Charlie Merrick, telling me something along the lines of: “Puerto Rico is a third-world credit borrowing at first-world interest rates.” Although Puerto Rico didn’t really meet my mind’s eye definition of third-world, there was a measure of truth to that.

Obviously, Puerto Rico has been in the news a lot recently due to hurricane related devastation and economic dislocation. I think it fair to say most of us in the contiguous United States simply can’t truly appreciate the level of destruction, let alone its duration. Oh yeah, compounding the problem is Puerto Rico is, quite literally, bankrupt.

Here is how Mary Williams Walsh reported part of the story in the New York Times on May 3, 2017 (the day of the bankruptcy filing):

“With its creditors at its heels and its coffers depleted, Puerto Rico sought what is essentially bankruptcy relief in federal court on Wednesday, the first time in history that an American state or territory had taken the extraordinary measure.

The action sent Puerto Rico, whose approximately $123 billion in debt and pension obligations far exceeds the $18 billion bankruptcy filed by Detroit in 2013, to uncharted ground.

While the court proceedings could eventually make the island solvent for the first time in decades, the more immediate repercussions will likely be grim: Government workers will forgo pension money, public health and infrastructure projects will go wanting, and the “brain drain” the island has been suffering as professionals move to the mainland could intensify.

Puerto Rico is “unable to provide its citizens effective services” because of the crushing weight of its debt, according to a filing on Wednesday by the federal board that has supervised the island’s financial affairs since last year.

The total includes about $74 billion in bond debt and $49 billion in unfunded pension obligations.

While many of Puerto Rico’s circumstances are unique, its case is also a warning sign for many American states and municipalities — such as Illinois and Philadelphia — that are facing some of the same strains, including rising pension costs, crumbling infrastructure, departing taxpayers and credit downgrades that make it more expensive to raise money. Historically, Puerto Rico was barred from declaring bankruptcy. In the end, however, financial reality trumped the statutes, and Congress enacted a law last year allowing bankruptcy-like proceedings.

Puerto Rico has been in a painful recession since 2006, and previous governments dug it deeper into debt by borrowing to pay operating expenses, year after year. For the last two years, officials have been seeking assistance from Washington, testifying before stern congressional committees and even making fast-track oral arguments before the United States Supreme Court.”

First things first: Puerto Rico is part of the United States. The rebuilding of the island’s infrastructure will be a Herculean task which will require a lot of money. Obviously, the local government doesn’t have it or access to affordable capital. As a result, Washington is going to shoulder the bill, either directly or indirectly.

We can all take a deep breath, because it is going to happen. At this point, it doesn’t matter how or why San Juan ran out of cash. It just did, and there are 3.5 million Puerto Ricans who currently would love to trade places with you.

In truth, this proves to be a cautionary tale. What happens when the money runs out and THEN bad things really start to happen? Trust me, this type of thing is going to happen a lot over the next couple of decades, if not maybe to this level of severity. After all, the current size of the US municipal bond market is around $3.8 trillion. Further, according to Moody’s in 2016, unfunded liabilities for US state public pension plans totaled roughly $1.75 trillion….that is the current unfunded status. A couple of years of returns below the actuarial assumption, let alone another 2008 or even 2000-2002, and look out. As an aside, that $1.75 trillion estimate is just that. I have seen others go as high as close to $6 trillion, but the sources aren’t as, um, reliable as Moody’s.

Whether we like it or not, local and even state entities simply don’t have the financial wherewithal to ‘get out’ of a disaster like the one presently facing Puerto Rico on their own. Not a chance, and it isn’t even close. Arguably the bigger problem is, and you guessed it, the US Treasury has already chalked up a $20 trillion, and growing, I.O.U.

Let’s just say the backstop has a pretty big hole in it.

Now, I freely admit the ramifications of amassing this mountain of debt, at all levels, haven’t been as severe as it would seem they should be. Quite the contrary. In fact, debt is cheaper now than it has been at just about any point in my career. To that end, back in the day, I remember thinking only a fool would lend the US Treasury money for 2-years for a 3.875% coupon! These days, Washington can get 30-year money for much less than that!

Even crazier is this: for every calendar year since the end of 2006, in nominal terms, Washington has added to its accumulated debt an amount greater than the annual increase in Gross Domestic Product. In other words, we have borrowed more than we have produced, or so it would seem. Clearly, this can’t be a good use of leverage.

Intuitively, this can’t last forever…or can it? Who would have thought it would have lasted this long?

I go through this exercise for a reason: Washington will ultimately take care of the physical rebuilding Puerto Rico after much gnashing of teeth and wringing of hands. However, it won’t be able to take care of every bankrupt public entity moving forward, let alone guarantee its debt, at least not at advantageous interest rates….no matter the public outcry for a “domestic Marshall Plan,” or something along those lines.

The reason is pretty simple: after World War II, the US ran current account surpluses (largely net trade surpluses), meaning it had ‘cash’ to export. Put another way, we were self-financing and could help to finance the rest of the world. The inverse is true today. The US runs massive current account surpluses, meaning we have to import cash to “balance the books.” In other words, we are NOT self-financing, and are subject to the proverbial whims of foreign investors….or the Federal Reserve to essentially print money out of thin air.

Now, I am not saying the shoe is getting ready to fall. It hasn’t yet and won’t this weekend. However, I think we would be very foolish to assume we can simply keep adding to our mountain of debt (here in the US and globally) interminably without something, shall I say, negative happening. Who knows? Maybe we can.

In the end, perhaps it is just my experience in the industry or my nature, but I have been and will likely continue to be hesitant to buy a lot of individual municipal securities, particularly smaller, more illiquid and opaque issues. If nothing else, the financial crisis in 2008 proved investors can’t, or shouldn’t, rely solely on ratings from S&P, Moody’s, etc., for their credit work. THEY are going to have to plow through some balance sheets, income statements, and prospectuses themselves. Even then, they will have to make an assessment on whether the data and estimates therein are valid and/or sustainable.

Put another way, you don’t want to be holding onto a fistful of odd lot, revenue municipal bonds issued by some unfamiliar places the next time a problem knocks on the door…either your door or theirs….unless you have, quite literally, done the math and the research. So, how much do you REALLY know about that hole in the wall place whose debt you just bought?

Charlie Merrick taught me that much.

 

Have a great weekend.

John Norris