World View: Financial Crisis Becomes Critical in Illinois and Puerto Rico


This morning’s key headlines from

  • Voting for statehood will not save Puerto Rico from financial crisis
  • Puerto Rico plunges into contentious bankruptcy proceedings
  • Illinois bond rating expected to be cut to junk status

Voting for statehood will not save Puerto Rico from financial crisis

Governor Ricardo Rosselló and Congresswoman representing Puerto Rico Jennifer Gonzalez celebrate the results of the statehood referendum (AP)
Governor Ricardo Rosselló and Congresswoman representing Puerto Rico Jennifer Gonzalez celebrate the results of the statehood referendum (AP)

On June 11, the citizens of Puerto Rico passed a non-binding referendum calling for Puerto Rico to be the 51st state of the United States. The vote was overwhelming – 97% voted “yes” on the referendum.

Puerto Rico’s governor Ricardo Rosselló said that he will create a commission to demand statehood from the U.S. Congress, which has to approve any changes to the island’s political status. Standing in front of a cheering crowd of supporters carrying U.S. flags and dancing to a tropical jingle that promoted statehood, Rosselló yelled:

The United States of America will have to obey the will of our people!

Whether Rosselló actually believes that non-sequitur, or whether he actually believes his fantasy claim that Puerto Rico’s financial crisis would now be solved by an influx of dollars from statehood, is not known. What is known with certainty is that Puerto Rico is not about to become a state.

The referendum was about as phony as a Russian presidential election. Only 23% of the electorate voted, because the vote was almost 100% boycotted by all opposition groups, including the majority of Puerto Ricans who consider their identity and their culture to be uniquely theirs and do not want to be an American state for any reason. The pro-statehood party, on the other hand, spent millions of dollars on a campaign, telling people that if they did not vote for statehood they would be deprived of their U.S. citizenship and promising millions in federal money if it became the 51st state.

For Puerto Rico to achieve statehood, Congress would have to approve. The population is overwhelmingly Democrats, so a Republican Congress will not be too interested. And statehood would mean that Puerto Rico would get five seats in the House of Representative, which means that five other states would lose one seat. It’s just not going to happen. ABC News (12-Jun) and The Atlantic and The Hill and CNBC (9-June)

Puerto Rico plunges into contentious bankruptcy proceedings

Puerto Rico owes $70 billion in bond debt and an additional $49 billion pension obligation to government employees. There’s is absolutely no possibility that those debts will ever be repaid.

Puerto Rico’s bonds have been tax exempt since 1917. Many people have invested in Puerto Rico bonds because they pay 10% interest (yields) and because under federal law they’re “triple-tax free.” This means that you could invest in Puerto Rico’s bonds and earn 10% interest every year, and not have to pay federal, state or municipal tax on the interest you collect. There were other major tax benefits granted exclusively to those investing in Puerto Rico.

The money that investors paid for these bonds has been essentially “free money” to Puerto Rico, since nobody there apparently believed that it would ever have to be paid back. As a result, Puerto Rico has felt free to spend huge amounts of money on social programs, with bills that are only now coming due.

The unemployment rate is 13.7%. Only 700,000 of the 3.5 million people, or 20%, work in the private sector. The other 80% either are on welfare, or they receive unemployment or other aid, or they work for the government. Year after year, Puerto Rico sold more and more bonds, and investors ate them up because of the high tax-free yields.

Through various financial tricks, Puerto Rico has managed to avoid bankruptcy until now, but bankruptcy proceedings finally began in May of this year.

A Puerto Rican default is likely to affect millions of Americans. Here’s an example of how mainland U.S. residents are affected: More than 40 percent of the Rochester Maryland Municipal Bond Fund and the Rochester Virginia Municipal Fund are invested in Puerto Rican bonds. Funds from Oppenheimer Funds and Franklin Templeton are heavily invested in Puerto Rico. If these funds collapse, public sector retirees and employees from states that invested in them will suffer.

The triple-tax free 10% interest deal has drawn massive amounts of money from 401k’s and other ordinary investment funds. These funds will all lose significant principal in a Puerto Rico default, which means that a lot of ordinary Americans will lose part or all of their savings. Daily Caller and NBC News (5-June) and The Nation (24-May)

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Illinois bond rating expected to be cut to junk status

When Illinois’ government missed an important deadline on June 1, rating agencies downgraded Illinois bonds to one step above junk status and warned that unless the political impasse is resolved by July 1, it was likely that they would be downgraded again, to junk status.

Illinois’ debt has been exploding. In May 2016, the state had $5.03 billion in unpaid bills. That has almost tripled in one year with spending obligations exceeding receipts by about $600 million per month. As of June 1 of this year, it owes a record $14.5 billion in unpaid bills. On top of that, unfunded pension liability has been exploding as well. The state has more than 660 government pension funds. The unfunded pension liability for the state’s five major plans is $251 billion, up 25% in the last year.

Pundits are claiming that Illinois’ situation is not as bad as Puerto Rico’s because Illinois is a wealthier state and can impose higher taxes. In one sense, the two are the same: There is no hope of ever paying off these debts.

Illinois has not passed a budget for the past two years. The Democrat-controlled legislature and Republican governor Bruce Rauner can’t agree about anything. It is this political chaos that caused the June 1 deadline to be missed, and the same chaos makes it likely that a July 1 deadline will also be missed, which will trigger the bond downgrade to junk status.

The downgrade to junk status will not immediately force the state into default, but it will raise interest rates significantly, caused the debt death spiral (or, as S&P calls it, the “negative credit spiral”) to accelerate. Anticipation of junk status is already affecting interest rates. Chicago public schools, which used to pay 4.64% interest on its bonds, are now paying an exorbitant 9%.

Other states are also facing serious debt spirals. According to a 2016 study by the Mercatus Center at George Mason University:

  • The best five states with regard to fiscal solvency are Alaska, Nebraska, Wyoming, North Dakota, and South Dakota.
  • The worst five states are: Kentucky, Illinois, New Jersey, Massachusetts, and Connecticut.

The rankings were based on cash solvency, budget solvency, long-run solvency, service-level solvency and trust fund solvency. and Zero Hedge and Bloomberg (1-June) and Barrons and Mercatus Center at George Mason University (2016)

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KEYS: Generational Dynamics, Puerto Rico, Ricardo Rosselló, Rochester Maryland Municipal Bond Fund, Rochester Virginia Municipal Fund, Oppenheimer Funds, Franklin Templeton, Illinois, Bruce Rauner, Mercatus Center
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