Bond Insurers Crash, Hit by Puerto Rico’s Default Shrapnel

On Monday, Puerto Rico’s government released a report that gave the municipal bond market the willies.

Written by former World Bank and IMF economists, it vivisects Puerto Rico’s finances, lays out the basic fact that the nearly $73 billion in bonds that the US commonwealth has outstanding, amounting to nearly 70% of its GDP, are of dubious value, and offers a debt restructuring strategy.

The report is decorated with financial doom and gloom: Outmigration has caused the population to drop nearly 8% since 2006 to 3.5 million today, even while the debt kept ballooning. It contained this choice passage:

The single most telling statistic in Puerto Rico is that only 40% of the adult population – versus 63% on the US mainland – is employed or looking for work; the rest are economically idle or working in the grey economy. In an economy with an abundance of unskilled labor, the reasons boil down to two.

– Employers are disinclined to hire workers because (a) the US federal minimum wage is very high relative to the local average (full-time employment at the minimum wage is equivalent to 77% of per capita income, versus 28% on the mainland) and a more binding constraint on employment (28% of hourly workers in Puerto Rico earn $8.50 or less versus only 3% on the mainland); and (b) local regulations pertaining to overtime, paid vacation, and dismissal are costly and more onerous than on the US mainland.

– Workers are disinclined to take up jobs because the welfare system provides generous benefits that often exceed what minimum wage employment yields; one estimate shows that a household of three eligible for food stamps, AFDC, Medicaid and utilities subsidies could receive $1,743 per month – as compared to a minimum wage earner’s take-home earnings of $1,159. The result of all of the above is massive underutilization of labor, foregone output, and waning competitiveness.

To fix this situation, bondholders are now asked to step up to the plate.

Governor Alejandro García Padilla told the New York Times that “the debt is not payable,” that there “is no other option,” that this “is not politics” but “math.” His administration is trying not to default, he said. “But we have to make the economy grow. If not, we will be in a death spiral.”

These are not the soothing words the bond market has been yearning for.

Puerto Rico is unlikely to make the debt payment due Wednesday, and if it can’t raise new money by selling additional debt, though it already can’t service its existing debt, the government said it might have to shut down by September, which would entail furloughs and other cash-preserving measures. Some analysts figured it could run out of money as early as July.

Ratings agency Fitch, upon hearing the good news on Monday, cut Puerto Rico’s general obligation bonds to CC, deep into junk territory, and kept it on Rating Watch negative, with further downgrades looming, to reflect, as Fitch said, its “belief that default of some kind appears probable….”

Beyond GOs – which Puerto Rico’s constitution says must be paid before government employees get paid – there are billions of dollars in bonds that public utilities and other entities have sold. On top of its bonds, it faces $37 billion in pension obligations. But unlike Detroit, the largest municipal bankruptcy in US history, Puerto Rico cannot use a bankruptcy process to shed its debts. It can only negotiate with creditors to restructure them.

Puerto Rico’s $73 billion in bonds are a lot of paper to spread around. Investors were lured with tax advantages, now obviated by events. If you own municipal bond mutual funds, chances are you own Puerto Rico bonds, though hedge funds have been buying them too. And those bonds just plunged on Monday.

But beyond bond funds, someone else is getting hit. Remember the bond insurers that were being shredded by the housing bust because they’d insured mortgage backed securities? They got hit again insuring junk.

Shares of bond insurers Ambac Financial dropped 11.9% on Monday. They’re down 26% from their 52-week high in January, and 43% from their lofty levels in February 2014.

Shares of Assured Guaranty fell 13.3% on Monday. After zigzagging up to their post-financial-crisis high just a week ago, they have plunged 19.4% in four trading days.

And MBIA, which insures about one-fifth of Puerto Rico’s municipal bonds, plunged 23.4% on Monday. MBIA was a highflyer before the Financial Crisis, trading at over $70 a share in late 2006,  before it all collapsed. Now, shares have crashed 33% over the past 5 trading days to $6.37 a share.

Analysts seemed surprised.

“Our buy ratings on Assured Guaranty and MBIA were predicated on our belief that the governor was going to do everything in his power to continue to repay [Puerto Rico’s] debt,” Mark Palmer, an analyst at the brokerage firm BTIG, told the Wall Street Journal after he belatedly downgraded Assured Guaranty and MBIA to neutral from buy, and maintained his neutral rating on Ambac.

Turns out, today everything changed. “A lot of the thinking about how Puerto Rico could dig itself out of the hole is no longer applicable,” he said.

Barclays could not rule out “scenarios in which multiple Puerto Rico issuers restructure their debt, which could cause significant loss” for MBIA and Ambac. Net charges of $750 million or more would degrade the insurers’ capital bases, which could lead to downgrades and diminished abilities to write new business, Barclays’ analysts told the Wall Street Journal, adding, “The current market value of uninsured Puerto Rico bonds suggests losses of this magnitude are at least possible.”

But these bonds are not the only municipal bonds Ambac, Assured Guaranty, and MBIA have insured. More hits, with echoes of the mortgage crisis, are waiting to happen.

Puerto Rico is the largest hiccup so far in the municipal bond market, preceded by the bankruptcies in recent years of Detroit, MI; Vallejo, San Bernardino, Stockton, and Mammoth Lakes, CA; Jefferson County, AL. Harrisburg, PA; Central Falls, RI; and Boise County, ID. Others, crushed by debts and pension obligations, are limping in that direction too.

When Meredith Whitney, who’d ridden to fame in 2007 on a prescient report about Citi, predicted in December 2010 that there would be “a spate of municipal-bond defaults,” namely, “50 to 100 sizable defaults, or more,” amounting to “hundreds of billions of dollars’ worth of defaults,” she only got the timing wrong. These things get kicked down the road for years until there’s no more road left. And then a default happens “suddenly.”

Evidence suggests that the US economy is muddling through, rather than falling off a cliff. But in many places, people think we’ve never left the recession behind. Turns out, they have good reason to feel that way. Read…  The Crucial Thing to Know About This Economy

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  17 comments for “Bond Insurers Crash, Hit by Puerto Rico’s Default Shrapnel

  1. Spencer says:

    Blow, baby blow. The contagion is spreading and the financial nuclear fallout will soon be upon us. I can’t wait to see what is on the other side. It is math alright govna, we will see how everything will add and subtract from here.

  2. Vespa P200E says:

    So Whitney was right all along and well ahead of the curve of the yield hungry muni investors who were enjoying relatively fat yield sans possibility of default and the schmuck insurers who once again made mistake of insuring the questionable muni bonds (one would think they learned from subprime debacles)?

    So here we are with the 1st wave of the defaults from GrEEKs and Puerto Ricans politicians who have been living off of other people’s money and give cushy government jobs as political favors. I suspect there will be more debt bombs going off since the worst offenders are fessing up.

    BTW – debt is either paid off or defaulted and sounds like there will be more defaults unless the creditors “forgive” some of the principals but we know how this script is played – more kabuki theater over kick the can down the road with creditors refusing to write off the bad debts…

    Yep we learn history as to learn from it and hopefully not repeat it as it’s not different this time…

  3. hidflect says:

    Since many economies are practicing ZIRP why doesn’t PR pretend that it’s holding the funds in a bank account paying 0% interest for the next 5 years to allow it to reform and recover?

  4. No surprises from economists working for banks: the credit problems in Puerto Rico are those at the bottom of the economic food chain.

    “Save us from them/ourselves!” the bankers cry. Next step: ‘huge’ concentration camps for ‘welfare recipients’. Let them eat cake … right?

    As human population declines one must ask, how many cars are in Puerto Rico? Too many, obviously! The cost of the cars + their necessary infrastructure cannot be met by way of ‘using’ the cars! They are simply driven in circles for ‘fun’ and ‘convenience’. “Oh, I have to go to work!” they cry. What work? Half of Puerto Ricans don’t work! They simply borrow from eager bankers so they can drive … just like everyone else on Planet Earth!

    Borrowing to drive is why the world is ‘encumbered’ with something like $800 trillion in debts! What else could it be? Humans can earn by stealing if necessary, cars earn nothing, they are anti-value, sucking capital out of every place they are to be found.

    How does it all end? Death camps for insolvent Puerto Ricans? All-out war to ‘protect’ the car interests? How about hanging a few bankers; a) who should have known better, b) corrupted the governments in PR, c) lent money they didn’t have (they are insolvent) and now will want a bailout that will cost more than all the Puerto Rican slave laborers put together.

    As for the cars … get rid of them. Anyone who owns a car in 2015 is going to get exactly what they deserve: impoverishment.

    … default in Greece, Puerto Rico, Argentina, Venezuela and elsewhere = Conservation by Other Means ™.

    • Vespa P200E says:

      I went to PR many times in 2005 to support a factory located in the western side of the island. Also supported another factory located in the southwest side of the island in the mid 90’s. Ponce Hilton felt like Ft Knox with high fences and security guards (there was casino there). I enjoyed with the people and appreciated the culture there. Folks there accepted me (don’t know why to this day) and I can tell you once you gain their trust and develop a “bond” they will go out of their way to protect and very loyal to you – truly good friends. My PR colleagues and plant management even asked my boss if I would be amenable to local short term assignment which was rare and my family joined me few times and to my daughters the beaches of Isabella and Rincon are better than Maui.

      To me it’s the US government taking away the punch bowl AKA tax break that started the rathole downturn in the PR economy. It started with high tech companies followed by medical and pharma plants closing their doors that began in the mid 90’s. Basically you have pool of trained and talented people the middle class out of work and that in turn does not bode well for non-English speaking lower rung of society. In the mean time you got 1 crook politician after another overspending and giving jobs for political favors while running huge deficit (sounds familiar?) and this can go so far. Harbinger of more to come in other “soverign” states…

  5. Sabbie says:

    The paragraph on why local companies will not hire is circular logic and complete rubbish.

    • Wolf Richter says:

      I don’t you think you read it carefully enough. It’s not the clearest paragraph I’ve ever read, so it requires a little effort, but it does make sense once you figure what the percentages relate to.

      • Sabbie says:

        Well we are dealing with a small tropical island in the Caribbean. So obviously productivity is going to be way lower here than the mainland. At the same time businesses must pay into the mainland pot (Federal taxes including the payroll variety and the money that funds welfare) but the Puerto Rican workers don’t pay Federal income tax. How would a lower minimum wage entice people off of welfare or support local spending?

        • Wolf Richter says:

          I see how you’re reading it. Thanks for the clarification. That’s not how I’m reading it. It’s not a proposal to cut the minimum wage. It’s not a proposal to do anything. It’s a statement or analysis of how the system is messed up and leads to counter-productive outcomes.

        • Vespa P200E says:

          Big deal back in 2005 in PR was the island was about to impose sales tax. People just could not stomach it (any my wife loved outlet shopping sans sales tax like OR).

          My personal experience has been that PR people worked very hard especially at the US multinational factories. I suspect it is hard to fire people so businesses try their darndest not to fill FTE position but resort to temp agencies.

  6. michael says:

    Its pretty obvious that a society based upon “takers” is not sustainable. Just wait until the shock waves hit the major cities across the mainland. I am sure all of our “leaders” will be shocked and suprised.

    • Vespa P200E says:

      Beyond the “takers” the cancer of local governments in US are pension “obligations” of proud card carrying public unions like teachers, police and firemen.

  7. NOTaREALmerican says:

    Well, luckily, this doesn’t apply to most “advanced” nations because as long as you can rollover your debt it’s really an asset.

    Maybe the IMF or some German banks would like to roll some PR debt?

  8. Michael says:

    Vespa you and I think much alike. I include all goverment in the take category.

  9. Brian Richards says:

    I know that many people in Puerto Rico are being badly affected by the government cutbacks, especially in the medical system. And it’s tough to make a living there. But I’ve found that the people, once you get to know them are intensely loyal to us “mainlanders”. Because of the ongoing financial crisis, I was able to buy a wonderful Neo Classical mansion in the central historic district in Ponce, and in the process of restoration, the Puerto Rican contractor and her husband have become life long friends. There actually may be a lot of opportunity in Puerto Rico now, since most Puerto Ricans have moved to NYC and Orlando. I encourage persons to check out the historic district real estate in Ponce. There are plenty of fine buildings needing restoration, and the South Coast is very nice. Email me if you want.

  10. Julian the Apostate says:

    I believe the dominos have begun to fall; they’ve managed to staunch the bleeding for now, but the aftershocks are coming.

  11. Petunia says:

    A Puerto Rican debt default will probably not even be noticed by the average Puerto Rican. They survive in spite of the US govt, which is why in my lifetime they have voted not to become a state. Most of those Puerto Ricans not working are retired with pensions they earned there and on the mainland. Many of my relatives did that and the island still attracts many retirees.

    The govt here and there has always worked against the interest of the people and they have learned to generally ignore it and try not to intersect with it. Although it is hard to make a living there the underground economy is a marvel to behold.

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